The following story about Big Muscles, a company in the fitness sector, il- lustrates how a management team came to realize the importance of giving realistic, conservative guidance:
Setting the Range
Some executives, when giving guidance, will choose a range straddling their internally budgeted earnings per share number. That is, if they think they’ll generate $0.13 per share for a quarter, they’ll choose to communicate a range of $0.12 to $0.14 believing analysts will pick the middle of the range. In actuality, companies should understand that there are many factors that they do not control, and given the fact that no one knows the future, they should be more conservative. For ex- ample, if management believes they’ll earn $0.13, the communicated range should be at most $0.11 to $0.13 per share. This positions the company to release earnings at the high end of the range if in fact they earn $0.13 as expected. However, if something happens out of man- agement’s control that adversely affects earnings and causes the com- pany to generate $0.12 per share, at least analysts will acknowledge that management hit the middle of the range and view it as a success- ful quarter. Under the original $0.12 to $0.14 range, management’s re- sults would be at the low end of the range and would most certainly be viewed as a negative. The key takeaway here is that management con- trolled the process in either case and was fully empowered to position itself for success.
128 DELIVERY
Going Down to Go Up
In November 2002, Big Muscles was trading at $14 per share and man- agement was telling The Street that its earnings for the following year would be $2.60 per share. For anyone who’s ever worked on Wall Street, those numbers just don’t add up.
To that point, IR told the CEO that if Wall Street believed the $2.60 estimate, the stock would be at least $20 per share. The CEO said that he was sure they’d deliver on that guidance, even though the CFO had doubts. Without access to the numbers at that time, a reasonable guess was that the company would earn $1.00 or so for 2003, not the $2.60 per share that management backed. Why? Because the market has a funny way of knowing the truth and a business like this was probably worth between 10x and 20x earnings, or $10-$15 per share, right where the stock currently was trading. The market had already figured it out and management was about to find out the hard way, but unfor- tunately IR can’t always convince a CEO on a mission.
As suspected, at the end of the first quarter of 2003, Big Muscles re- alized they’d need to adjust guidance to $1.50–$1.60. IR strongly sug- gested they go even lower, because analysts and investors were still wary of the numbers. The stock was trading at $11 per share at this point.
Based on experience and the stock price, IR suggested guidance of
$1.00, which is what the market was intimating they would earn any- way. Despite the material revision, the stock likely wouldn’t go much lower, and some investors and analysts might even start to believe again. Management disagreed with this advice and went out with their guidance of $1.50 to $1.60 per share.
At the end of the second quarter, Big Muscles missed estimates again. IR attempted the same conversation, but added that Street intel- ligence was saying that both the sell- and buy-side thought the company was out of control, they had zero trust in management, and thought they were “completely unrealistic.”
The CEO ultimately lost his job. The new CEO asked the CFO to review forecasts and lay out a conservative estimate, a number he could give with 95 percent confidence. The stock would not go down, IR pre- sumed; rather it would stay at $11 or actually go up as the short sellers covered. The CFO’s number was $1.00–$1.10.
The Street was still expecting the earnings number for the year to be
$1.50, but during this call, management came out, took the heat, and
announced that it missed the second quarter, and new estimates would be $1.00–$1.10.
The Street reacted noisily and investors called management to vent.
Analysts issued negative reports.
Following the call, IR gathered intelligence that Wall Street, de- spite the frustration, felt that this was guidance management could de- liver on. Some actually implied that they might get positive on the stock again. The next day, after the conference call, the stock went up 10 percent.
Three months later, on October 28, 2003, management held a con- ference call to announce the third-quarter numbers. The new CEO de- livered the good news that the company had beaten the quarterly esti- mate by a penny. But he also detailed ongoing challenges, talked about the turnaround, gaining control, and stabilizing growth. He clarified that this would take 9 to 12 months and that there would be no growth until 4Q of 2004. That is, he gave conservative, realistic guidance.
The next day, the stock traded 2 million shares versus its usual av- erage of 200,000 and it shot up to $16 per share. The analyst headlines read: “Fog Is Clearing, Raising Rating to Market Perform,” “Signs of Life in 3Q, Worst May Be Behind,” and “Turning Around?”
One analyst wrote: “Yesterday, October 28, after the close, Big Muscles released its 3Q earnings of $0.20, which was in line with com- pany guidance and ahead of the consensus of $0.19, we were on the low end of the street at $0.17. We raised our rating on Big Muscles as management seems to have stabilized business, with hopes of a return to growth in coming years.”
And though most of the sell- and the buy-side felt the company still had problems, and maybe kept their neutral ratings, they now believed the management team finally had a plan to turn it around, and they ap- plauded it in print. One who’d said he’d despised the company for an entire year and once called the executives “a band of fools who could- n’t shoot straight” said he was going to raise his rating from market un- derperform to market perform.
This was a clear case of a CEO who felt aggressive guidance was somehow going to fight off short sellers and keep the stock price at propped-up levels. In reality, this CEO was not open to IR advice and didn’t really understand the nuances of the stock market. By refusing to adopt a conservative guidance philosophy, he increased the overall risk to shareholders and, as many have said, lost his job in the process.
Figure 16.1 shows an example of how a company can release guidance to the sell-side, buy-side, and media as part of an earnings release.