Information has been collected, relative value has been determined, and IR

has helped the company define its investment story. The next step is communicating

that story. Delivery is the act of reaching out to Wall Street. This

stage of IR ideally puts the company in a position to increase visibility and

create value.

The first part of the delivery stage is making sure that all the pieces of

the package are in place. Preparation for delivery involves

Establishing company-backed earnings estimates through guidance and

managing expectations, through investor relations and corporate communications,

to that guidance.

Targeting the audience of analysts and portfolio managers.

Setting up a communications process that integrates PR and IR, in

which the two functions coordinate as a united front and develop the

appropriate messages. This should lower the communication risk for the

entire organization.

Evaluating infrastructure needs to do the best job possible at the lowest

cost, and double-checking with legal counsel that all disclosure policies

are in place.

The second part of the delivery stage is reaching out, which includes

providing the investment community with information and access to management

through earnings announcements, conference calls, and, when appropriate,

pre-announcements.

IR should be spearheading each step of the delivery process. Although

some management teams choose not be overly interactive with the world,

the fact of the matter is that all CEOs and CFOs are highly judged on (1) all

communications that derive from headquarters and (2) whether or not they

communicate to Wall Street’s standards.

The delivery stage of IR is really the tool for value creation. Delivery fits

in organically with all of the steps of IR and is anchored around the schedules,

disclosures, and engagements that a company has with the capital markets.

The objective is to do it better and more effectively than the thousands

of other companies trying to surface through all the white noise of publicly

traded companies.

GUIDANCE

Guidance straddles definition and delivery. In the definition stage, while developing

the investment message, management and IR must also review internal

budgets and determine the impact that future plans will have on the

bottom line. This should be mixed with a qualitative communications strategy

that together with a conservative quantitative outlook allows portfolio

managers and analysts to make investment decisions. Developing this part of

the message, the financial guidance, is the bridge between definition and delivery

and sets the tone for all communications to follow.

Guidance is certainly a controversial topic, and even some of the most

respected investors in the country have advised against it. Yet, guidance is a

critical part of the pact between a public company and its investors, and an

issue that management teams should take very seriously.

THE LINCHPIN OF EFFECTIVE IR

Before going into further specifics of delivery, it’s a worthwhile exercise to dig

deeper into guidance, because it’s one of two or three issues that IR and management

must agree on before actually delivering its message to The Street.

Guidance is ultimately about managing expectations and positioning a

company conservatively in the capital markets. It also is a value-creation

tool used to build credibility over time. What comes with building credibility

over time? In most cases, a higher multiple, a better valuation, and increased

wealth for management and shareholders.

For various reasons, however, the positive impact of guidance is lost on

many management teams, so they have chosen not to issue estimates. Unfortunately,

this leaves analysts on their own to build models and make assumptions.

That fact increases risk for the buy-side in that analysts are publishing

estimates that may be too high for the company to achieve.

IR professionals who are former analysts know how confusing this can

be. A lack of guidance can leave the sell-side in a sea of potential misinterpretation,

forcing them to establish their own parameters, and often causing

doubt about management’s forecasting capabilities.

In other words, analysts don’t like the absence of guidance, and here’s

why. They are asking the buy-side to put investor money to work based on

their recommendations. Analysts are also asking their institutional sales

forces to trust them with their ideas, and call institutions to generate Buy

and Sell orders. If management is too promotional with guidance or doesn’t

give any at all, it puts the analysts’ credibility in jeopardy, and these are the

people the company needs most over the long run. Particularly in the case of

no guidance, where management refuses to quantify the future, the analysts

end up completely blind in developing forecasts.

Management input has always been an important part of the process.

The analyst is someone the company wants to protect whenever possible,

and protection in this case means conservative guidance based on conservative

and transparent assumptions. In the case of aggressive guidance,

where there is no guarantee that estimates will be achieved, management

may ultimately burn the analyst by materially missing numbers and in turn

torpedo the trust between analyst and sales force and analyst and portfolio

manager.

A good relationship with the sell-side can help a company and protect

shareholder value over the long run. That’s why Investor Relations must

bring a capital markets perspective to the argument and make sure that the

CEO and CFO are fully informed on the debate.

GIVING GUIDANCE

Guidance establishes parameters for investors and analysts rather than allowing

those investors and analysts to establish parameters themselves.

These forecasts, which might be for the upcoming quarter and/or the upcoming

year, are usually set and refined during earnings announcements or

in any given quarter when management is tracking materially away from the

consensus view.

The not-so-subtle point of guidance therefore, is to make sure that management

is the only party that sets the bar by which the company is measured.

Because analysts will publish estimates regardless, management should

seize the opportunity and take control of an earnings number that will exist

anyway. Allowing the analyst community to set that bar in a vacuum is just

too risky. Now more than ever, with many inexperienced analysts at the

To Guide or Not To Guide: That Is the Question 125

helm, management should always define itself or the company risks being in

position to miss estimates and jeopardize its equity value and cost of capital.

SHORT-TERM GUIDANCE VS.

SHORTSIGHTED GUIDANCE

In our experience, the companies that do not practice guidance tend to do so

under one of two misconceptions. The first false belief is that guidance

forces management to run its business based on short-term earnings expectations.

They think that the obsession with short-term results is Wall Street’s

fault, and companies don’t want to play that game. In reality, there’s no

game to be played; many executives simply don’t understand the nuances of

the stock market. The second hurdle to guidance is that management thinks

it’s impossible to forecast that far in advance.

Wall Street’s game-playing—the focus on short-term earnings during the

boom days of the market—wasn’t Wall Street’s fault at all. It was primarily

the fault of management teams, who in most cases had compensation incentives

tied to short-term stock performance. People do exactly what they are

paid to do, and if a CEO has a truckload of three-year options, he or she will

probably do whatever it takes to deliver a high stock price in three years.

Compensation issues aside, however, management teams have always

been fully empowered to adopt and implement strategies that put long-term

shareholder returns ahead of short-term results. Yet, just because these decisions

may produce weaker near-term earnings and a temporarily lower stock

price, it doesn’t mean that management should either worry unnecessarily

about the short-term drop, particularly if the drop was caused by investment

in the future, or stop guiding The Street. Their new guidance can simply be

more conservative based on higher spending for important future initiatives.

The second reason that some management teams opt out of guidance is

because they aren’t confident in their forecasting abilities. Fair enough.

However, Wall Street understands that no company can predict with certainty

what it will earn to the penny this year or next. But what companies

should do is make assumptions on the variables that they can control, estimate

what they can’t control, and put forth an estimate, or better yet, a

broad estimate range. The SEC’s Safe Harbor provisions and other legal disclaimers

protect that estimate and range, and as the quarters go by, management

should commit to systematically refining it further, either up or down,

to reflect current business. It’s transparent and informative, and Wall Street

often rewards that behavior with a premium multiple.

Lack of guidance, in our opinion, can be a sign that management either can’t forecast its business or for legal reasons isn’t willing to talk about the

future. In the latter case, if the lawyers simply dominate the debate and

make the decision, management should be extremely careful about intraquarter

conversations with analysts and portfolio managers regarding the

business. Without formally disseminated guidance, these conversations set

the stage for a Reg FD violation that can cost from several hundred thousands

of dollars into the millions. Even that cost is not reflective of the damage

to reputation that would come with a slip-up of this nature.

THE NUANCES OF GIVING GUIDANCE

The following story about Big Muscles, a company in the fitness sector, illustrates

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 example,

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 management’s

control that adversely affects earnings and causes the company

to generate $0.12 per share, at least analysts will acknowledge

that management hit the middle of the range and view it as a successful

quarter. Under the original $0.12 to $0.14 range, management’s results

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 controlled

the process in either case and was fully empowered to position

itself for success.

Going Down to Go Up

In November 2002, Big Muscles was trading at $14 per share and management

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 unfortunately

IR can’t always convince a CEO on a mission.

As suspected, at the end of the first quarter of 2003, Big Muscles realized

they’d need to adjust guidance to $1.50–$1.60. IR strongly suggested

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 anyway.

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 intelligence

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 presumed;

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

To Guide or Not To Guide: That Is the Question 129

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, despite

the frustration, felt that this was guidance management could deliver

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 conference

call to announce the third-quarter numbers. The new CEO delivered

the good news that the company had beaten the quarterly estimate

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 average

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 company

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 applauded

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 couldn’t

shoot straight” said he was going to raise his rating from market underperform

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.

THE CONSENSUS NUMBER

Analysts assess guidance and factor management’s input into their own

analysis when modeling earnings estimates. More often than not, they take

management’s lead and use the company’s assumptions and oftentimes the

actual earnings estimates for their own predictions. Right there, the power

of guidance is revealed.

These numbers get played twice, however: once in each analyst’s research

report and then again as part of the consensus estimate, which is an average

calculated from all analysts’ forecasts. The overwhelming majority of investors

and the financial media judge a company and management based on the average

number, also known as the First Call consensus estimate. In as much as a

company can control it, they should attempt to give specific guidance to analysts,

with the end goal of influencing the First Call estimate. Again, why

should anyone other than the CEO or CFO set the performance bar?

That’s not to say that analyst estimates can’t be higher or lower than

management intended. Analysts are free to publish what they want. However,

if the consensus estimate is too high, either management did not adequately

communicate why the estimate should have been lower or one or

more of the company’s analysts are being aggressive for other reasons. Because

they are commission players, some analysts attempt to stand out from

the crowd by posting a higher estimate than that which has been blessed by

management, which leads the buy-side to wonder if this analyst knows

something that the other analysts don’t and may lead to a phone call or a

new relationship. This is great for the analyst and can mean greater compensation

levels. But these heroics can skew the consensus estimate upward,

causing the company to miss earnings even though management was conservative

with its EPS forecast.

That’s why an argument of the underlying assumptions is so critical.

The company gets on record with its own assumptions, and should a miss

occur because of the analyst, management is largely forgiven.

THE CONSENSUS WITHOUT GUIDANCE

Wall Street’s job is to boil everything management says down to an earnings

per share estimate and place a valuation on those earnings. Therefore, when

Octagon Inc. Reports Third Quarter Financial Results

Raises Guidance for Fiscal 2003; Introduces Guidance for 2004

A Sample Section of a Release Updating Guidance

Octagon Inc. updated its guidance for the fourth quarter ending December 31,

2003. The Company currently expects fourth quarter sales to range between $28

million and $30 million and diluted earnings per share to range from $0.06 to $0.08,

inclusive of the estimated $0.04 per share negative impact of the preferred stock

repurchase and subordinated debt pre-payment. In comparison, during the fourth

quarter of 2002 the Company reported sales of $25.8 million and earnings per

share of $0.13. It is important to note that last year’s fourth quarter results included

a one-time after tax gain of $168,000, or $0.02 per diluted share, related to the final

settlement of the Hexagon litigation. In addition, due to the timing of the Circle

Square acquisition, which closed on October 20, 2002, the Company paid slightly

more than one month of interest on the borrowings associated with the purchase.

In the fourth quarter of fiscal 2003 the Company expects to pay three full months of

interest on the aforementioned borrowing, aggregating approximately an additional

$650,000, or $0.03 per diluted share. Also, given the timing of the Circle Square acquisition,

there are no substantial incremental royalty savings between the fourth

quarters of 2003 and 2002 as the vast majority of fourth quarter royalty savings

were already realized last year. Accounting for these various items, the fourth quarter

2002 diluted earnings per share excluding the $0.02 gain on litigation settlement

and including an additional two months of interest of $0.03 would have yielded a

pro forma diluted earnings per share of $0.08; whereas, the expected fourth quarter

2003 diluted earnings per share excluding the $0.04 for debt repayment and

preferred stock repurchase would yield a pro forma estimate of approximately

$0.10 to $0.12, a 25% to 50% improvement compared to the $0.08 pro forma 2002

amount. See the accompanying table entitled “Pro Forma Diluted Earnings Per

Share Comparison” for a presentation of the reconciliation in tabular format.

The Company also raised its guidance for the fiscal year ending December 31,

2003. The Company now expects 2003 sales to range between $113 million and

$115 million and diluted earnings per share to range from $0.62 to $0.64.The Company

expects its Circle Square sales to be $74 million to $75 million, Simple to be

approximately $8 million and Triangle to be $31 million to $32 million.

A Sample Section of a Release Providing New Guidance

The Company is introducing guidance for fiscal 2004. Octagon Inc. currently

anticipates its fiscal 2004 sales to be in the range of $126 million to $132 million, including

$82 to $84 million for Circle Square, $9 to $11 million for Rectangle and $35

to $37 million for Triangle. Octagon Inc. currently expects its diluted earnings per

share for fiscal 2004 to range from $0.92 to $0.96.

FIGURE 16.1 Guidance Examples

a company announces a strategic initiative without quantifying that initiative,

it may be interpreted to mean $0.03 per share to one analyst, $0.05 per

share to another analyst, and $0.15 per share to another. These numbers, in

all their disparity, are figured into the consensus number and posted on First

Call. These First Call quarterly earnings targets are generated constantly,

whether or not a company has issued guidance.

A company that announces a material event without quantifying the

event for Wall Street loses control of the estimates and increases the risk that

the bar will be set where it can’t be achieved.

NOT TO MENTION REG FD

Formal guidance on conference calls and in press releases is also for Reg FD

purposes in that it acts as a company’s template for disclosure.

During the spring of 2003, a technology manufacturer made a public

announcement about a particular initiative, and used the qualitative term

“significant” to describe its impact on the company’s future performance.

This claim was not backed up with quantitative guidance and it led to confusion

among the analysts, who then called the company to follow up on the

quantitative translation of “significant.” The company defined the word,

but only to the analysts who asked, to mean a rate of change of 25 percent

or more. According to the SEC, the company “violated fair disclosure rules

by communicating material non-public information in a manner inconsistent

with Regulation FD.” Had the company just quantified that statement in a

public forum, they never would have been in a position to violate Reg FD.

More generally speaking, any company that practices no guidance,

technically, would not be able to take private calls from analysts who, as

part of their jobs, must constantly refine their future numbers. It makes

management look evasive, it’s a legal risk, and in our opinion decreases

the odds that new analysts will publish and makes the institutional buyers

of stocks uneasy. Therefore, a pretty good argument can be made

that not giving guidance penalizes a company’s valuation and carries

with it about just as much risk as giving guidance, which confounds

most corporate legal teams.

FIGHTING OPTIMISM

Anyone who plays golf knows that, in a money match, a 15 handicap

who claims to be a 20 will win before the match begins. Some players do

the exact opposite and brag about their game, stating that they are a 17

handicap when they are a 20. Of course, this golfer has lost before the

match begins.

Guidance can be the same way. Before the year begins, every company

has the opportunity to influence the First Call consensus through a conservative,

self-set bogey. This allows management to establish an estimate that

is achievable.

Management may not want to give certain guidance, however, because

they believe the number is too conservative and the stock price will suffer in

the short run. In fact, many CEOs are just too optimistic or promotional as

part of their job. So when IR suggests leading with 15 percent growth when

the CEO believes growth is 25 percent, they bristle.

The reality is that if the CEO started with lower guidance and raised it

throughout the year as business tracks to internal budget, the price and valuation

would most likely be stronger. The other benefit to starting conservative

is the fact that throughout the year, conditions out of the company’s

control invariably happen to negatively affect earnings. It’s a nice feeling for

management to be able to keep guidance intact while others are guiding

downward.

Aggressive guidance can also be bad for the business, not just Wall

Street. For example, if a company refused to guide to an IR-recommended

15 percent earnings growth and wanted to issue 25 percent because it felt

the odds of achieving that number were 50/50 and only “a couple of things

would have to go right to make the number,” that would be too much risk.

Initially, that level of guidance would, in all likelihood, propel the stock upward.

However, Wall Street, as it always does, would come to discover the

risk. That vulnerability would potentially attract short-sellers, discourage

sell-side analysts from publishing (why write research for a hold rating that

won’t generate commissions?), and cause the buy-side to stay on the sidelines.

That’s too much at risk for a 50/50 chance.

THE CONSERVATIVE TIGHTROPE

Companies need to communicate in a way such that their assumptions and

estimates are interpreted as they are intended. In order for the value story to

be heard as truth, and for management’s credibility to be enduring, management

has to walk a fine line. That’s a line between being conservative enough

to keep expectations from getting out of hand and being too conservative

and giving The Street a reason to question management candor. Sandbagging

is unacceptable, but it’s far different from being conservative.

To Guide or Not To Guide: That Is the Question 133

During the late 1990s, many companies tried to sandbag estimates so

they could easily beat them and make everyone happy, every quarter. Unbeknownst

to management, that behavior becomes expected, for example, if

management usually beats the estimate by 10 percent, a 9 percent overage is

a disappointment. When that happens, simply meeting guidance is considered

negative, and a company can expect its stock to go down. It’s a terrible

cycle of pleasing The Street. Management should perform, guide, and deliver

in a conservative, not grossly underestimated, fashion.

Guidance is a subjective and highly strategic pursuit, but the results are

tangible in the following ways:

In general, conservative guidance positions any company for a Buy

rating from the sell-side. Also, it rarely lets the stock price spike, a

source of volatility. A slow and steady appreciation in share price is always

preferred.

Conservative guidance allows the sell-side to feel confident and publish

on a company’s stock. The analyst will look his/her sales force in the

eyes and tell them that management is great at dealing with The Street,

they are conservative, and business is good. They’ll do the same with the

buy-side.

The credibility management builds by meeting the bar they’ve set for

themselves goes right to valuation, right to employee morale, right to

vendors, and right to the media, which will tend to write more positively

than negatively over time.

A great example was a recent Deutsche Bank research report on

GTECH Holdings, the on-line lottery operator in Rhode Island. The headline

of the report read: “GTECH Reports Solid 4Q, but Management Remains

Firm on Conservative Guidance.” In addition, the third bullet in the

first page reads, “Citing the integration of four acquisitions this year, management

has set the bar low. After having beaten FY04’s initial guidance by

14%-18% by year end, we think management is maintaining its pattern of

underperforming and over-delivering.”

Finally, “All in, while we would have liked guidance to have been higher

we believe estimates will likely increase over the remainder of the year, consistent

with the last two years of earnings trends. In addition, we believe

management has historically been conservative.” The leisure analyst rated

the stock a Buy and in the report looked for 25 percent appreciation.

This type of conservative guidance attracted the sell-side, investors became

involved and management looked great, building credibility over a

long period of time. So who engineered this strategy? Well, GTECH has a

To Guide or Not To Guide: That Is the Question 135

great management team and IR function, but it doesn’t hurt that the chairman

was formerly a very well-respected sell-side analyst.

In our opinion, conservative guidance can fuel a powerful cycle, where

equity value is maximized, Wall Street benefits, and the entire organization

becomes stronger. It works in many ways, such as:

Management establishes conservative guidance, which lowers the risk

profile of the stock.

The sell-side analysts see an undervalued story and begin to publish.

The buy-side analysts get involved, also looking for companies positioned

to succeed.

Management then meets or exceeds First Call consensus, which they

had a major hand in influencing. At the same time they make another

argument why estimates should remain low for the upcoming quarter

and year. Again, they are positioning themselves to succeed.

Employees see the results and are invigorated, and vendors want to be a

part of success.

The media latches on and writes favorably, which fuels productivity,

pride, and an organization with momentum.

And that leads to better earnings.

This pattern of building credibility with conservative guidance ultimately

can position the company for a better valuation than its peers and a

lower cost of capital.

Information has been collected, relative value has been determined, and IR

has helped the company define its investment story. The next step is communicating

that story. Delivery is the act of reaching out to Wall Street. This

stage of IR ideally puts the company in a position to increase visibility and

create value.

The first part of the delivery stage is making sure that all the pieces of

the package are in place. Preparation for delivery involves

Establishing company-backed earnings estimates through guidance and

managing expectations, through investor relations and corporate communications,

to that guidance.

Targeting the audience of analysts and portfolio managers.

Setting up a communications process that integrates PR and IR, in

which the two functions coordinate as a united front and develop the

appropriate messages. This should lower the communication risk for the

entire organization.

Evaluating infrastructure needs to do the best job possible at the lowest

cost, and double-checking with legal counsel that all disclosure policies

are in place.

The second part of the delivery stage is reaching out, which includes

providing the investment community with information and access to management

through earnings announcements, conference calls, and, when appropriate,

pre-announcements.

IR should be spearheading each step of the delivery process. Although

some management teams choose not be overly interactive with the world,

the fact of the matter is that all CEOs and CFOs are highly judged on (1) all

communications that derive from headquarters and (2) whether or not they

communicate to Wall Street’s standards.

The delivery stage of IR is really the tool for value creation. Delivery fits

in organically with all of the steps of IR and is anchored around the schedules,

disclosures, and engagements that a company has with the capital markets.

The objective is to do it better and more effectively than the thousands

of other companies trying to surface through all the white noise of publicly

traded companies.

GUIDANCE

Guidance straddles definition and delivery. In the definition stage, while developing

the investment message, management and IR must also review internal

budgets and determine the impact that future plans will have on the

bottom line. This should be mixed with a qualitative communications strategy

that together with a conservative quantitative outlook allows portfolio

managers and analysts to make investment decisions. Developing this part of

the message, the financial guidance, is the bridge between definition and delivery

and sets the tone for all communications to follow.

Guidance is certainly a controversial topic, and even some of the most

respected investors in the country have advised against it. Yet, guidance is a

critical part of the pact between a public company and its investors, and an

issue that management teams should take very seriously.

THE LINCHPIN OF EFFECTIVE IR

Before going into further specifics of delivery, it’s a worthwhile exercise to dig

deeper into guidance, because it’s one of two or three issues that IR and management

must agree on before actually delivering its message to The Street.

Guidance is ultimately about managing expectations and positioning a

company conservatively in the capital markets. It also is a value-creation

tool used to build credibility over time. What comes with building credibility

over time? In most cases, a higher multiple, a better valuation, and increased

wealth for management and shareholders.

For various reasons, however, the positive impact of guidance is lost on

many management teams, so they have chosen not to issue estimates. Unfortunately,

this leaves analysts on their own to build models and make assumptions.

That fact increases risk for the buy-side in that analysts are publishing

estimates that may be too high for the company to achieve.

IR professionals who are former analysts know how confusing this can

be. A lack of guidance can leave the sell-side in a sea of potential misinterpretation,

forcing them to establish their own parameters, and often causing

doubt about management’s forecasting capabilities.

In other words, analysts don’t like the absence of guidance, and here’s

why. They are asking the buy-side to put investor money to work based on

their recommendations. Analysts are also asking their institutional sales

forces to trust them with their ideas, and call institutions to generate Buy

and Sell orders. If management is too promotional with guidance or doesn’t

give any at all, it puts the analysts’ credibility in jeopardy, and these are the

people the company needs most over the long run. Particularly in the case of

no guidance, where management refuses to quantify the future, the analysts

end up completely blind in developing forecasts.

Management input has always been an important part of the process.

The analyst is someone the company wants to protect whenever possible,

and protection in this case means conservative guidance based on conservative

and transparent assumptions. In the case of aggressive guidance,

where there is no guarantee that estimates will be achieved, management

may ultimately burn the analyst by materially missing numbers and in turn

torpedo the trust between analyst and sales force and analyst and portfolio

manager.

A good relationship with the sell-side can help a company and protect

shareholder value over the long run. That’s why Investor Relations must

bring a capital markets perspective to the argument and make sure that the

CEO and CFO are fully informed on the debate.

GIVING GUIDANCE

Guidance establishes parameters for investors and analysts rather than allowing

those investors and analysts to establish parameters themselves.

These forecasts, which might be for the upcoming quarter and/or the upcoming

year, are usually set and refined during earnings announcements or

in any given quarter when management is tracking materially away from the

consensus view.

The not-so-subtle point of guidance therefore, is to make sure that management

is the only party that sets the bar by which the company is measured.

Because analysts will publish estimates regardless, management should

seize the opportunity and take control of an earnings number that will exist

anyway. Allowing the analyst community to set that bar in a vacuum is just

too risky. Now more than ever, with many inexperienced analysts at the

To Guide or Not To Guide: That Is the Question 125

helm, management should always define itself or the company risks being in

position to miss estimates and jeopardize its equity value and cost of capital.

SHORT-TERM GUIDANCE VS.

SHORTSIGHTED GUIDANCE

In our experience, the companies that do not practice guidance tend to do so

under one of two misconceptions. The first false belief is that guidance

forces management to run its business based on short-term earnings expectations.

They think that the obsession with short-term results is Wall Street’s

fault, and companies don’t want to play that game. In reality, there’s no

game to be played; many executives simply don’t understand the nuances of

the stock market. The second hurdle to guidance is that management thinks

it’s impossible to forecast that far in advance.

Wall Street’s game-playing—the focus on short-term earnings during the

boom days of the market—wasn’t Wall Street’s fault at all. It was primarily

the fault of management teams, who in most cases had compensation incentives

tied to short-term stock performance. People do exactly what they are

paid to do, and if a CEO has a truckload of three-year options, he or she will

probably do whatever it takes to deliver a high stock price in three years.

Compensation issues aside, however, management teams have always

been fully empowered to adopt and implement strategies that put long-term

shareholder returns ahead of short-term results. Yet, just because these decisions

may produce weaker near-term earnings and a temporarily lower stock

price, it doesn’t mean that management should either worry unnecessarily

about the short-term drop, particularly if the drop was caused by investment

in the future, or stop guiding The Street. Their new guidance can simply be

more conservative based on higher spending for important future initiatives.

The second reason that some management teams opt out of guidance is

because they aren’t confident in their forecasting abilities. Fair enough.

However, Wall Street understands that no company can predict with certainty

what it will earn to the penny this year or next. But what companies

should do is make assumptions on the variables that they can control, estimate

what they can’t control, and put forth an estimate, or better yet, a

broad estimate range. The SEC’s Safe Harbor provisions and other legal disclaimers

protect that estimate and range, and as the quarters go by, management

should commit to systematically refining it further, either up or down,

to reflect current business. It’s transparent and informative, and Wall Street

often rewards that behavior with a premium multiple.

Lack of guidance, in our opinion, can be a sign that management either can’t forecast its business or for legal reasons isn’t willing to talk about the

future. In the latter case, if the lawyers simply dominate the debate and

make the decision, management should be extremely careful about intraquarter

conversations with analysts and portfolio managers regarding the

business. Without formally disseminated guidance, these conversations set

the stage for a Reg FD violation that can cost from several hundred thousands

of dollars into the millions. Even that cost is not reflective of the damage

to reputation that would come with a slip-up of this nature.

THE NUANCES OF GIVING GUIDANCE

The following story about Big Muscles, a company in the fitness sector, illustrates

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 example,

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 management’s

control that adversely affects earnings and causes the company

to generate $0.12 per share, at least analysts will acknowledge

that management hit the middle of the range and view it as a successful

quarter. Under the original $0.12 to $0.14 range, management’s results

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 controlled

the process in either case and was fully empowered to position

itself for success.

Going Down to Go Up

In November 2002, Big Muscles was trading at $14 per share and management

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 unfortunately

IR can’t always convince a CEO on a mission.

As suspected, at the end of the first quarter of 2003, Big Muscles realized

they’d need to adjust guidance to $1.50–$1.60. IR strongly suggested

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 anyway.

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 intelligence

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 presumed;

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

To Guide or Not To Guide: That Is the Question 129

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, despite

the frustration, felt that this was guidance management could deliver

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 conference

call to announce the third-quarter numbers. The new CEO delivered

the good news that the company had beaten the quarterly estimate

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 average

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 company

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 applauded

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 couldn’t

shoot straight” said he was going to raise his rating from market underperform

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.

THE CONSENSUS NUMBER

Analysts assess guidance and factor management’s input into their own

analysis when modeling earnings estimates. More often than not, they take

management’s lead and use the company’s assumptions and oftentimes the

actual earnings estimates for their own predictions. Right there, the power

of guidance is revealed.

These numbers get played twice, however: once in each analyst’s research

report and then again as part of the consensus estimate, which is an average

calculated from all analysts’ forecasts. The overwhelming majority of investors

and the financial media judge a company and management based on the average

number, also known as the First Call consensus estimate. In as much as a

company can control it, they should attempt to give specific guidance to analysts,

with the end goal of influencing the First Call estimate. Again, why

should anyone other than the CEO or CFO set the performance bar?

That’s not to say that analyst estimates can’t be higher or lower than

management intended. Analysts are free to publish what they want. However,

if the consensus estimate is too high, either management did not adequately

communicate why the estimate should have been lower or one or

more of the company’s analysts are being aggressive for other reasons. Because

they are commission players, some analysts attempt to stand out from

the crowd by posting a higher estimate than that which has been blessed by

management, which leads the buy-side to wonder if this analyst knows

something that the other analysts don’t and may lead to a phone call or a

new relationship. This is great for the analyst and can mean greater compensation

levels. But these heroics can skew the consensus estimate upward,

causing the company to miss earnings even though management was conservative

with its EPS forecast.

That’s why an argument of the underlying assumptions is so critical.

The company gets on record with its own assumptions, and should a miss

occur because of the analyst, management is largely forgiven.

THE CONSENSUS WITHOUT GUIDANCE

Wall Street’s job is to boil everything management says down to an earnings

per share estimate and place a valuation on those earnings. Therefore, when

Octagon Inc. Reports Third Quarter Financial Results

Raises Guidance for Fiscal 2003; Introduces Guidance for 2004

A Sample Section of a Release Updating Guidance

Octagon Inc. updated its guidance for the fourth quarter ending December 31,

2003. The Company currently expects fourth quarter sales to range between $28

million and $30 million and diluted earnings per share to range from $0.06 to $0.08,

inclusive of the estimated $0.04 per share negative impact of the preferred stock

repurchase and subordinated debt pre-payment. In comparison, during the fourth

quarter of 2002 the Company reported sales of $25.8 million and earnings per

share of $0.13. It is important to note that last year’s fourth quarter results included

a one-time after tax gain of $168,000, or $0.02 per diluted share, related to the final

settlement of the Hexagon litigation. In addition, due to the timing of the Circle

Square acquisition, which closed on October 20, 2002, the Company paid slightly

more than one month of interest on the borrowings associated with the purchase.

In the fourth quarter of fiscal 2003 the Company expects to pay three full months of

interest on the aforementioned borrowing, aggregating approximately an additional

$650,000, or $0.03 per diluted share. Also, given the timing of the Circle Square acquisition,

there are no substantial incremental royalty savings between the fourth

quarters of 2003 and 2002 as the vast majority of fourth quarter royalty savings

were already realized last year. Accounting for these various items, the fourth quarter

2002 diluted earnings per share excluding the $0.02 gain on litigation settlement

and including an additional two months of interest of $0.03 would have yielded a

pro forma diluted earnings per share of $0.08; whereas, the expected fourth quarter

2003 diluted earnings per share excluding the $0.04 for debt repayment and

preferred stock repurchase would yield a pro forma estimate of approximately

$0.10 to $0.12, a 25% to 50% improvement compared to the $0.08 pro forma 2002

amount. See the accompanying table entitled “Pro Forma Diluted Earnings Per

Share Comparison” for a presentation of the reconciliation in tabular format.

The Company also raised its guidance for the fiscal year ending December 31,

2003. The Company now expects 2003 sales to range between $113 million and

$115 million and diluted earnings per share to range from $0.62 to $0.64.The Company

expects its Circle Square sales to be $74 million to $75 million, Simple to be

approximately $8 million and Triangle to be $31 million to $32 million.

A Sample Section of a Release Providing New Guidance

The Company is introducing guidance for fiscal 2004. Octagon Inc. currently

anticipates its fiscal 2004 sales to be in the range of $126 million to $132 million, including

$82 to $84 million for Circle Square, $9 to $11 million for Rectangle and $35

to $37 million for Triangle. Octagon Inc. currently expects its diluted earnings per

share for fiscal 2004 to range from $0.92 to $0.96.

FIGURE 16.1 Guidance Examples

a company announces a strategic initiative without quantifying that initiative,

it may be interpreted to mean $0.03 per share to one analyst, $0.05 per

share to another analyst, and $0.15 per share to another. These numbers, in

all their disparity, are figured into the consensus number and posted on First

Call. These First Call quarterly earnings targets are generated constantly,

whether or not a company has issued guidance.

A company that announces a material event without quantifying the

event for Wall Street loses control of the estimates and increases the risk that

the bar will be set where it can’t be achieved.

NOT TO MENTION REG FD

Formal guidance on conference calls and in press releases is also for Reg FD

purposes in that it acts as a company’s template for disclosure.

During the spring of 2003, a technology manufacturer made a public

announcement about a particular initiative, and used the qualitative term

“significant” to describe its impact on the company’s future performance.

This claim was not backed up with quantitative guidance and it led to confusion

among the analysts, who then called the company to follow up on the

quantitative translation of “significant.” The company defined the word,

but only to the analysts who asked, to mean a rate of change of 25 percent

or more. According to the SEC, the company “violated fair disclosure rules

by communicating material non-public information in a manner inconsistent

with Regulation FD.” Had the company just quantified that statement in a

public forum, they never would have been in a position to violate Reg FD.

More generally speaking, any company that practices no guidance,

technically, would not be able to take private calls from analysts who, as

part of their jobs, must constantly refine their future numbers. It makes

management look evasive, it’s a legal risk, and in our opinion decreases

the odds that new analysts will publish and makes the institutional buyers

of stocks uneasy. Therefore, a pretty good argument can be made

that not giving guidance penalizes a company’s valuation and carries

with it about just as much risk as giving guidance, which confounds

most corporate legal teams.

FIGHTING OPTIMISM

Anyone who plays golf knows that, in a money match, a 15 handicap

who claims to be a 20 will win before the match begins. Some players do

the exact opposite and brag about their game, stating that they are a 17

handicap when they are a 20. Of course, this golfer has lost before the

match begins.

Guidance can be the same way. Before the year begins, every company

has the opportunity to influence the First Call consensus through a conservative,

self-set bogey. This allows management to establish an estimate that

is achievable.

Management may not want to give certain guidance, however, because

they believe the number is too conservative and the stock price will suffer in

the short run. In fact, many CEOs are just too optimistic or promotional as

part of their job. So when IR suggests leading with 15 percent growth when

the CEO believes growth is 25 percent, they bristle.

The reality is that if the CEO started with lower guidance and raised it

throughout the year as business tracks to internal budget, the price and valuation

would most likely be stronger. The other benefit to starting conservative

is the fact that throughout the year, conditions out of the company’s

control invariably happen to negatively affect earnings. It’s a nice feeling for

management to be able to keep guidance intact while others are guiding

downward.

Aggressive guidance can also be bad for the business, not just Wall

Street. For example, if a company refused to guide to an IR-recommended

15 percent earnings growth and wanted to issue 25 percent because it felt

the odds of achieving that number were 50/50 and only “a couple of things

would have to go right to make the number,” that would be too much risk.

Initially, that level of guidance would, in all likelihood, propel the stock upward.

However, Wall Street, as it always does, would come to discover the

risk. That vulnerability would potentially attract short-sellers, discourage

sell-side analysts from publishing (why write research for a hold rating that

won’t generate commissions?), and cause the buy-side to stay on the sidelines.

That’s too much at risk for a 50/50 chance.

THE CONSERVATIVE TIGHTROPE

Companies need to communicate in a way such that their assumptions and

estimates are interpreted as they are intended. In order for the value story to

be heard as truth, and for management’s credibility to be enduring, management

has to walk a fine line. That’s a line between being conservative enough

to keep expectations from getting out of hand and being too conservative

and giving The Street a reason to question management candor. Sandbagging

is unacceptable, but it’s far different from being conservative.

To Guide or Not To Guide: That Is the Question 133

During the late 1990s, many companies tried to sandbag estimates so

they could easily beat them and make everyone happy, every quarter. Unbeknownst

to management, that behavior becomes expected, for example, if

management usually beats the estimate by 10 percent, a 9 percent overage is

a disappointment. When that happens, simply meeting guidance is considered

negative, and a company can expect its stock to go down. It’s a terrible

cycle of pleasing The Street. Management should perform, guide, and deliver

in a conservative, not grossly underestimated, fashion.

Guidance is a subjective and highly strategic pursuit, but the results are

tangible in the following ways:

In general, conservative guidance positions any company for a Buy

rating from the sell-side. Also, it rarely lets the stock price spike, a

source of volatility. A slow and steady appreciation in share price is always

preferred.

Conservative guidance allows the sell-side to feel confident and publish

on a company’s stock. The analyst will look his/her sales force in the

eyes and tell them that management is great at dealing with The Street,

they are conservative, and business is good. They’ll do the same with the

buy-side.

The credibility management builds by meeting the bar they’ve set for

themselves goes right to valuation, right to employee morale, right to

vendors, and right to the media, which will tend to write more positively

than negatively over time.

A great example was a recent Deutsche Bank research report on

GTECH Holdings, the on-line lottery operator in Rhode Island. The headline

of the report read: “GTECH Reports Solid 4Q, but Management Remains

Firm on Conservative Guidance.” In addition, the third bullet in the

first page reads, “Citing the integration of four acquisitions this year, management

has set the bar low. After having beaten FY04’s initial guidance by

14%-18% by year end, we think management is maintaining its pattern of

underperforming and over-delivering.”

Finally, “All in, while we would have liked guidance to have been higher

we believe estimates will likely increase over the remainder of the year, consistent

with the last two years of earnings trends. In addition, we believe

management has historically been conservative.” The leisure analyst rated

the stock a Buy and in the report looked for 25 percent appreciation.

This type of conservative guidance attracted the sell-side, investors became

involved and management looked great, building credibility over a

long period of time. So who engineered this strategy? Well, GTECH has a

To Guide or Not To Guide: That Is the Question 135

great management team and IR function, but it doesn’t hurt that the chairman

was formerly a very well-respected sell-side analyst.

In our opinion, conservative guidance can fuel a powerful cycle, where

equity value is maximized, Wall Street benefits, and the entire organization

becomes stronger. It works in many ways, such as:

Management establishes conservative guidance, which lowers the risk

profile of the stock.

The sell-side analysts see an undervalued story and begin to publish.

The buy-side analysts get involved, also looking for companies positioned

to succeed.

Management then meets or exceeds First Call consensus, which they

had a major hand in influencing. At the same time they make another

argument why estimates should remain low for the upcoming quarter

and year. Again, they are positioning themselves to succeed.

Employees see the results and are invigorated, and vendors want to be a

part of success.

The media latches on and writes favorably, which fuels productivity,

pride, and an organization with momentum.

And that leads to better earnings.

This pattern of building credibility with conservative guidance ultimately

can position the company for a better valuation than its peers and a

lower cost of capital.