CHAPTER 24 Event Management

As part of the Dialogue stage, IR must react appropriately to positive and

negative events, in order to enhance or preserve valuation at any given

time. To best anticipate and negotiate the inevitable, IR must (a) always have

the proper information available in the form of market data and market

feedback, (b) have a relationship with the CEO based on respect so that

management can absorb and take direction from IR depending on the circumstances,

and (c) help management plan its short- and long-term strategies

with an understanding of the potential effects on the market.

INFORMATION FLOW

In order to make an informed decision based on unexpected events, IR must

have the proper information available at all times. For internal IR at a larger

company, this means subscribing directly to third-party information vendors.

A smaller company can depend on agencies for these services. In addition

to the important real-time data, IR must also gather investor perception

and feedback, and combining the two should make any tough decision that

much easier.

Third-Party Information Systems

In order to monitor the markets and the unexpected events that invariably

occur, IR must have access to the following:

Stock quotes: Not only the company’s day-to-day stock price movements,

but its peer group’s. This is the first line of defense in keeping an

eye on market perception of an individual company or group.

First Call: A company can gauge the effectiveness of its message and

guidance by checking analyst research and recommendations and, of

course, the First Call earnings estimates. IR should also gather research

reports on competitors and the sector, and process any new information

that surfaces.

Trading: The Autex Rankings gather trading volume in stocks by investment

bank and shows which banks are active in any particular stock

at any given time. These figures can be an indicator of company or sector

expertise, or the banks’ willingness to commit capital on the trading

desk.

Ownership: IR needs to extract, from shareholder databases, a list of

the new owners, existing owners who have added to their positions, and

those who have sold their stock. This is mandatory when performing a

cross-ownership analysis for targeting, particularly when a stock is

dropping.

Conference call transcripts: Transcripts are the best way to track material

events in the industry.

IR should package this information for management, so they can

glimpse a quarterly scorecard of sorts and form an idea of how the company

is being perceived against its peers.

Garnering Feedback

Part of that packaged information should also include old-fashioned buyand

sell-side feedback. This information, in the form of informal conversations,

estimate revisions or recommendation changes, or the actual buying

or selling of stock, is the purest form of judgment. But feedback sometimes

can be tough to find.

Analysts

In terms of the sell-side, even a 15-minute conversation during earnings season

can be asking a lot, so IR must come across as an informed peer who can

talk credibly about valuation and industry events. Also, if IR can be a gatekeeper

to a deeper relationship with management, that will also earn respect.

Ultimately, IR must use whatever leverage it has to engage the analyst and

extract the market’s current perception. An inexperienced subordinate, with

a checklist list of questions will almost always be ineffective.

Investors

Investors purchase stocks because they believe the financial outlook is positive

relative to the current price, and they sell stocks when they believe the

opposite is true.

Investors with large stakes in companies have a particular interest that

the company do well financially, and this objective gives IR an opportunity

to reach into the thought processes of the buy-side and garner any

perception that’s relevant, such as the investment highlights as the PM

sees them.

Information from an institution that has not purchased stock in the

company, but is buying the competition, is equally valuable to IR. Obtaining

this investor’s insights can lead to uniquely helpful and constructive criticism.

These are tough-to-access, unique opinions because the investor is obviously

interested and bullish on the sector, but has some reservations about

the company in question. Perhaps the investor is harboring reservations

about the success of the business or even skepticism about management.

Short Sellers

Similarly, IR should always be aware of short interest and why certain investors

are betting that the company won’t live up to expectations. Although

short sellers are tough investors for IR to pin down directly, even

the second-hand story can give management the ammunition to prepare a

counter argument.

Wall Street’s Hot Buttons

In any given sector at any given time, companies are doing business and generating

news. Because the stock market moves on how that news might affect

financial performance, it’s safe to say that there is always something to

react to in the IR department. Examples are foreign exchange rates, a pending

port strike, back to school’s shaping of inventory levels, a shift in demographics,

a thrust in teen spending, or the overcrowding of a market that

stalls expansion and suppresses growth. IR should always be prepared to tailor

dialogue based on the issues affecting the company’s sector.

This awareness is especially important when drafting the conference call

script and deciding which issues require emphasis or even inclusion.

Another method of handling unforeseen events is to launch a pre-emptive

strike and take control of the information. Tread Lightly, a footwear manufacturer, had a large amount of its business flowing through one retailer.

Thanks to Regulation FD, companies can’t disclose anything to The

Street that IR professionals can’t also access.

The IR community discovered that the retailer was receiving certain exclusive

agreements from a competitor, Putya Foot Down. We knew that the

retailer was not receiving any such agreements from Tread Lightly, and that

these agreements would give the retailer incentive to feature Putya Foot

Down products to shoppers with price reductions and special displays. This

would, of course, hurt Tread Lightly’s volume and presumably its stock

price.

Given that the retailer was Tread Lightly’s biggest customer, investors

and analysts would estimate a drop in sales. Tread Lightly’s IR advisors had

the company consider this possibility before The Street did so that they

could reconcile it with their strategy, make adjustments, and address the

issue with the investment community.

Another reason to stay on top of industry events is to draft off of others’

momentum. A company had recently licensed a hot brand for one of its

product lines. IR heard from The Street that a huge retailer was touting this

particular brand, cheering its recent volume in its stores. The opportunity Swell Sweaters Inc. and Sophisticated Shirts Corp., two companies in

the clothing industry, were trading at similar multiples. Then Swell

Sweaters started doing very well based on an emerging sports trend

while Sophisticated Shirts was pulled down by a portfolio that, by contrast,

seemed outdated.

Timeless Tops also competed in this sector. They had the preppy

image as well, but their value and quality stayed popular with teens.

Yet, Timeless Tops’ stock was trading at a discount, and IR’s information

(stock performance, First Call, shareholder analysis) pointed to the

fact that the preppy image was probably the reason.

IR wasn’t sure, though, and reached out to The Street for reconnaissance.

After talks with several portfolio managers, IR found, instead,

that the concern was low inventory and faltering sales. This news

was delivered back to Timeless Tops and a strategy emerged.

Their next communication to The Street immediately addressed

these issues and articulated current initiatives as part of the company’s

strategy. The misperception was corrected, but without the proper information,

handling this event would have been impossible.

arose for the company to capitalize on the buzz and start communicating its

success with the brand but in a context that included conservative guidance.

This easy, quick maneuver gained significant IR and PR attention, positioning

the company to exceed estimates and create long-term value.

Analysts and investors see many companies fail to stay in touch with

trends that affect valuation within their own sector. IR needs to remain diligent

for management, collect the information, interpret it, and determine

what course is best to maximize valuation.

If IR doesn’t already know the sector’s overarching messages each quarter,

it’s bound to discover them too late. Anticipating these hot buttons keeps

the company ahead of the audience.

THE IR/CEO RELATIONSHIP

The most crucial element for productive dialogue with The Street is the management/

IR relationship. IR must be an effective and reliable liaison between

The Street and the company, and the CEO must believe that IR lends him or

her a new perspective. Too many yes-men around the CEO can be awful for

shareholders, but sometimes a domineering CEO has no interest in hearing

critical feedback. The role of the IRO or the outside IR counsel is to bridge

the gap between the company and the capital markets, stand up to the CEO

when no one else will, and bring Wall Street’s perspective to the discussion.

The Emperor Has No Clothes

For IR to be effective, management and the board of directors must trust the

function and give IR full immunity to create a secure conduit to and from

The Street. Given the fact that access is king on Wall Street, and criticizing a

CEO jeopardizes that access, some management teams become insulated

from reality, particularly when the CEO’s ego is an issue. This situation demands

a strong, objective hand to come in for a reality check.

In 2002, a fairly new, but very successful technology company saw its

products gathering momentum. As a result of its success, the company publicly

set high financial goals, which seemed set to garner a high short-term

valuation. Subsequently, executives felt pressure to meet those goals and

were trapped in a make-the-number pattern that crushed so many companies

at that time.

Management, as well as IR, failed this company in several respects.

There was no managing of expectations, guidance was aggressive, short-term

Bankers came to management with a few solutions. One suggested

that Paperclip consider an acquisition to build the business. Another

thought that management should refinance the bank debt with an issue

of high-yield bonds. Yet another suggested selling the company.

An IR audit included a discussion with the buy- and sell-sides. Both

analysts and investors felt that management had an antagonistic attitude

toward the capital markets and was unwilling to listen to feedback,

often fighting back when analysts shared criticism or shutting off

investors who had complaints. The Street also felt that quarter after

quarter, the company would hold back bad news, even when they knew

they were going to hit unexpected, one-time charges that would cause

the earnings to fall short.

This management team was fighting the entire credibility checklist.

Within the company there was no accountability, the numbers were not

transparent, the managers didn’t anticipate problems, and they were

hardly visible to The Street. The Street didn’t care what the value

proposition was, because management had no standing with the investment

community.

IR brought the information back to management. The good news

was that The Street felt Paperclip’s stock could be very attractive if

management pulled its act together. The bad news was that management’s

lack of credibility had sunk the valuation to such depths that

each of the capitalization maneuvers they were considering offered only

symptomatic relief; none, even selling the company, would bring the

shareholders the value that the board felt was appropriate.

Paperclip needed to reposition its story and regain Wall Street’s

trust. IR suggested making the following changes and communicating

them on the next conference call:

Change the tone of all communications from defensive and arrogant

to conciliatory.

Streamline the profile to reflect a simple, organized business model.

Organize an internal audit to create department-by-department accountability.

Direct valuations to focus on EBITDA, not earnings.

Begin cost-cutting initiatives.

(continued)

Other credibility cases don’t turn out as well. Inevitably, despite the best

strategies, negative opinions surface. Because a lot of money is on the line

when analysts make a positive or a negative recommendation, they are very

careful in their assessment of management and in their valuation argument.

One thing that some management teams fail to recognize, however, is

that nothing personal is involved in the process. It’s simply an opinion based

on assumption. Companies that fail to understand this and publicly antagonize

analysts simply end up looking foolish, demonstrating a lack of capital

markets savvy and, ultimately, hurting shareholders.

Executives must find a way to absorb negative opinions and not get into

a defensive volley with analysts, although it happens frequently. Several instances

of management-analyst antagonism have occurred in the past few

years. According to a June 19, 2003, article in The Wall Street Journal, after

two Morgan Stanley analysts questioned Qwest Communications’ accounting,

Qwest denied analyst access to Morgan Stanley and wouldn’t consider

the firm for banking business. The Journal also stated that a former chief executive

“publicly derided the analysts and questioned the integrity of their

work.” Morgan Stanley continued to downgrade the stock to a Sell rating.

The Journal article also reported on a telecommunications analyst at J.P.

Morgan Chase who questioned whether Nextel Communications was lowballing

its bad debt estimates. Within hours, the Journal said, Nextel’s CFO

was on the phone to the analyst’s boss, “accusing the analyst of faulty work.”

In these situations, the companies looked foolish, management lost credibility,

and the shareholders suffered because the stocks dropped. IR with an

understanding of the research process could have headed off this antagonism

and subsequent damage to valuation.

Ultimately, if a company wants to be public and benefit from raising

capital and selling shares, CEOs and CFOs have to understand Wall Street

and also accept the negatives.

Each of these moves sent a signal to The Street that Paperclip’s

management team was accountable, transparent, credible, and candid.

The bankers stepped back and investors stayed with the stock or became

newly involved.

This company had a good business, a good story, and a good plan.

IR helped them adapt short-term goals that would stay true to the longterm

strategy and keep the company honest with The Street. The dissemination

of this story to The Street gained the company increased

coverage and new sell-side distribution and buy-side volume.

Being Upfront with Information

Human nature is to want to position any event in the best light possible, but

analysts are skeptical about promotion. Using superlatives that generate

high expectations puts more risk in the public domain than most analysts or

investors are willing to tolerate; more often than not, analysts and the buyside

steer clear of a heavily promoted stock. For that reason, any company

that tries to spin an obviously negative event into something positive will be

found out in due time. Management credibility and company valuation will

be erased.

HANDLING BAD EVENTS (AND LOWERING GUIDANCE)

Three basics apply to IR’s handling of bad events: don’t delay, don’t divide,

and don’t diminish.

1. Don’t delay: Management should weigh the benefits against the risk of

being one of the last companies in an industry to report. If a material

event occurs and there are risks of rumors in the marketplace, management

wants investors to hear the news from them first. It’s far better to

take control of the situation and define the problem rather than sitting

on bad news and allowing rumors to define the company’s reality. Management

should get a handle on what the news means to the bottom line

and deliver it.

2. Don’t divide: Telling the whole story to all constituents at once helps

 “One of the most important things a CFO must do is articulately communicate

what is going on in the company to outside constituents and

do it with credibility. That’s always been important, but it’s even more

so today.

—David Viniar, CFO, Goldman Sachs

“You get no pretense with David. He’s the opposite of slick. In evaluating

a complex company that takes on a lot of risk, like Goldman,

that makes me comfortable,”

—anonymous investor on David Viniar.

Source: February 2004 Institutional Investor

take the risk out of the news, even if it’s bad. Ideally, management

should never allow another shoe to drop. If bad news does dribble out,

the analyst has no choice but to negatively comment on every announcement.

This painful, drawn-out process will affect future earnings

and the stock’s multiple will likely compress.

A slow roll-out of bad news has a ripple effect as the media latches

on to the problems, and as employees and vendors lose confidence in

management. These factors can fundamentally weaken the business,

leading to a low valuation and a high cost of capital.

Companies need to get all bad news out at once if possible. Explain

it, quantify it, boil it down to conservative earnings guidance, and rebuild

the share base through effective targeting.

3. Don’t diminish: Management must be transparent and accountable

because analysts ultimately listen to management teams that own up

to mistakes. They don’t want to hear excuses that downplay the

news.

We knew a company that treated earnings releases as an opportunity to

promote the business. They glossed over financial results in favor of promotional

language that always cast the business in the best light. The fact was,

management was viewed poorly by The Street despite their chronically rosy

outlook that attempted to perpetually mask poor earnings. That game can

be played only so many times without investors running for the exits. In fact,

they did.

Another often-used excuse is blaming poor earnings on events outside of

management’s control, such as the economy, weather, or our recent favorite,

“geopolitical issues.” This type of deflection, although sometimes very true,

can often be a management crutch. One company had for several quarters

had been blaming sub-par performance on the economy. At the same time

industry peers were announcing positive results in those same markets due

to a rebounding economy. IR’s job is to monitor competitor results because,

as in this case, it can avoid embarrassment. Had management blamed the

economy again when others were doing well, credibility would have been

further damaged. This is just another example of a proactive IR effort managing

an unexpected event.

THE OPTIMAL TIME TO LOWER GUIDANCE

One of the most important events that a management team faces is lowering

guidance. In determining the best time to do so, IR should take into account

stock price and valuation. That check can be the difference between the

stock getting trounced and the stock increasing on high volume.

If the stock price is at a 52-week low, the valuation is at a big discount

to its peer group, and the analyst community is relatively disengaged—that

is, no one has a Strong Buy rating—management has greater leeway to reduce

guidance without hurting the analyst, the investor, or its own credibility.

In all likelihood The Street is expecting very little from management performance-

wise given this scenario, and the market might just be waiting for

management to reassess its expected earnings guidance. Bringing guidance

down under these circumstances would result in lower risk, more attention,

and probably an increased stock price.

However, if the valuation is high—say, because the CEO wanted to use

25 percent EPS guidance rather than 15 percent as the IRO suggested—management

must take its medicine and lower expectations. To minimize the

risk, the company should do this after the market closes in a press release

with a simultaneous conference call to explain the factors. This is the best

way to lessen the risk of a situation that management and IR both know will

result in a falling stock price.

When readjusting guidance, management cannot be married to a bestcase

number. In fact, given the choice of lowering a $1.10 estimate by $0.05

or $0.10, management should always take the latter, particularly if the stock

is drifting downward. The reason is that another $0.05 reduction isn’t going

to matter as much to The Street as if the company positions itself to miss revised

guidance. Additionally, when setting guidance, management must do

so with an eye to the future. Most events are usually not a one-quarter phenomenon,

and The Street will suspect that subsequent quarters may come in

low. When the company sets guidance, it needs to establish a conservative

cushion for the rest of the year, without, of course, setting itself up to materially

exceed the number either. To set the company up for success, guidance

must be both realistic and achievable.

HANDLING GOOD EVENTS

One quarter after another of terrific results is every company’s dream, but

this is where IR hits the double diamond trails of keeping a check on management

ego and managing The Street’s expectations. In order to stay on

course and not be dissuaded by the stock price, IR must script a bit of conservatism

or push back in every quarter when there is great success. Management

must always be in control of its numbers via guidance, and an analyst

or two over-hyping the company is an analyst or two too many.

Another by-product of positive news is the invariable analyst downgrade.

As mentioned throughout this book, analysts are in the business of

generating commissions; therefore, a large part of their job is to upgrade and

downgrade stocks. In theory, this activity guides the decisions of the buy-side

and in the process drives trading volumes for the investment bank.

The analyst downgrade should never be taken personally, and CEOs

should understand that when his or her stock price reaches the analyst target,

action will be taken. Either the analyst will up the price target and reiterate

her Buy rating or downgrade the stock, saying it’s fully valued.

IR’s task, through conservative guidance primarily, is to manage expectations

to the point where the company has built significant credibility. At

that point, an analyst typically downgrades based on valuation only. In

other words, the analyst isn’t lowering his rating because the business model

is flawed or because management has lost credibility. He is lowering is because

the stock hit the target price.

This downgrade is the best that a company can hope for, and it might

read something like this:

Analyst Paul Hewson from American Securities writes, “Based solely on

valuation, we are lowering our rating to Underperform from Marketperform.

We continue to view this as a good company that has met or

exceeded our expectations. However, with the sharp run-up in share

price, we believe the stock is considerably ahead of current expectations.

Victory’s stock has appreciated by more than 40% in the last couple of

months, from the mid-teens to more than $20 per share. Our 12 month

price target remains unchanged.”

Again, managing the analyst community relative to good news is just as

important as doing so when the news is bad. Because the buy-side pays more

attention to the content of any report versus the rating, a downgrade such as

the one above is a big victory for the company and IR.

How does a company control investor expectations when the business is

on fire? An article in The Wall Street Journal, March 25, 2004, was titled

“Investors Cut Starbucks Some Rare Slack.” With the subhead, “Coffee

Chain’s Decade of Frothy Performance Overshadows Chairman’s Growth

Warning.”

The article states: “When a top executive warns investors that his company

won’t be able to sustain its rate of growth, the result is usually a stock

sell off. But that didn’t happen on Feb. 25th when Howard Shultz, chairman

of Starbucks Corp., announced that the world’s largest chain of coffee shops

couldn’t keep getting larger at rates as fast as 32%. Sure the stock slipped,

but only 3.4%, and then it bounced back a day or two, perhaps because the

company nevertheless stood by double-digit sales-growth expectations. As

for analysts, their recommendations remained neutral or positive, with most

of them predicting that Starbucks would outperform the market. This faith

in Starbucks certainly doesn’t arise from any sense that the stock is undervalued.

In recent days, the price-to-earnings ratio of Starbucks stock has

flirted with 50, making it one of the most expensive stocks on Wall Street.”

. . . “Rather, the market reaction—or lack of reaction—suggests that a rare

type of credibility gap is developing between Starbucks and the Street. It is

the opposite of the gap that forms between hype-prone executives and shareholders.

This type of gap reflects no suspicion, no sense among investors that

the executive is trying to fool them or gin up a quick bump in the stock; instead,

there’s a sense that this executive is hard on himself and his company,

and therefore his self-effacement isn’t entirely credible.” The article compares

this credibility gap with that developed around Warren Buffett and the

late Sam Walton.

This approach to restraining, or at least trying to restrain, The Street allows

management to focus on the business and The Street to worry about

valuation.

MANAGEMENT AND LANGUAGE

One of the most important parts of a company’s ongoing dialogue with The

Street is the actual language that’s used on a day-to-day basis. To that end,

management and IR shouldn’t underestimate the impact of the words they

use. For example, if a CEO is asked how he feels about his company’s most

recent guidance and starts his answer with the phrase, “Several things have

to happen for us to deliver . . . ,” investors might sell a share or two.

In order to script and oversee a conservative communication’s plan, IR

has to make sure that all language is tempered and delivered in terms that

The Street is used to hearing. A company should never say emphatically that

“we will,” but rather “we believe,” “we should,” or “we expect.”

Nor can the language be nebulous. A company which states that they

are going to “make a significant investment in cap ex” or “generate substantial

earnings potential” without quantifying such terms is giving openended

guidance, which is dangerous. Analysts and investors must translate

words to numbers or any number of variations could come out of those

phrases. For example, “substantial earnings potential” from a new initiative

might mean 5 cents in one analyst’s model and 15 cents in another analyst’s

model. The result would be a wide-ranging, higher than intended, First Call

consensus estimate that management, deep down, knows is unattainable.

Words, whether referring to guidance or when issuing new news, should always

be quantified, with an earnings per share range and a time frame that

foots with that financial guidance.

Words are just the beginning. As we mentioned earlier, in the late summer

of 2003, the SEC cited a Reg FD violation based on “tone, emphasis

and demeanor” to Schering-Plough. The IRO was present at the time of

the infraction, which illuminates the fact that even some of biggest IR executives

can’t be expert enough on the ever-changing regulations on financial

disclosure. Staying within the limits of the right words and phrases,

not to mention the appropriate body language is not easy. That’s what

makes systematic, scripted disclosure, with clear and quantifiable guidance,

essential.

Finally, it’s also helpful in the Dialogue stage if everyone is speaking the

same language.

Big Hand Accessories, a consumer products company, kept telling The

Street that their business wasn’t seasonal, and that, in fact, the reason

the company was so profitable was because it was not seasonal, which

was confusing to IR consultants who worked with them. Their accessories

clearly sold better in summer than winter.

When we asked the CEO about this, he explained that when they

were not selling in North America, they were selling in Australia at a

different time of year. He was quite surprised when we told him that by

using the word “seasonal,” not only was he not clearly explaining the

situation, but he was creating the impression that he didn’t understand

it either.

Curious that this didn’t come up in calls, the IR team asked some

of the analysts and investors why they had never questioned the CEO

on his use of this word. They said that they thought that they were

missing something obvious and they were waiting to figure it out before

asking.

IR decided to clear this up and scripted the next call to do just that.

In the call, the CEO explained that the business adapts to the market

with less SKUs by creating products that avoid obsolescence because

they transfer easily.

That solved that problem.

THE MARKET EFFECTS OF SHORT- AND

LONG-TERM STRATEGIES

On a quarter-to-quarter basis, P&L and balance sheet items change with financial

performance, and each change is another event that must be properly

explained to Wall Street. Although this book certainly couldn’t address

every possible variation, in most situations strategic IR is able to clarify the

issues and communicate them properly.

State of Affairs and Their Effects

LIFO, FIFO: Inventory levels send strong signals to The Street and may be

misinterpreted if they’re not backed by a logical story. For example, slower

inventory turns can sometimes foretell an earnings slowdown, or a retailer

may experience inventory levels that appear higher than sales can sustain.

In many industries, inventory levels and turns are cyclical, but sometimes

they indicate a particular shift in the marketplace. This situation can

be specific to a particular company, because of something that’s happened to

its product or service or those of its competitors. Or the situation can be specific

to the industry, like a shift in demographics or the economy that affects

buying tendencies or consumer tastes.

Investors that smell an inventory problem on the balance sheet may

be prompted to sell shares. But if the company has the chance to explain

that these inventory levels are built into the projections for, let’s say, new

stores coming on line, a shifting marketplace, or a proven strategy, the investors

will see a viable asset, one that will be monetized and benefit the bottom

line.

A/R and COGS: There are times when expenses, specifically cost of

goods sold (COGS), are contested. This can happen when companies do not

believe that they owe their suppliers or vendors certain expenses or that they

were overcharged for expenses that are directly related to the cost of making

the products they sell.

Some companies, when they contest this number, may assume they are

either not going to have to pay the contested amount or that they are going

to get a refund on payments already made. Then they don’t even recognize

this expense as a cost at all, deleting it altogether from COGS. Those who

expect a refund may go so far as to book it as a receivable. This type of expense

refuting or refund claim inflates earnings. If Wall Street sees this tactic

in the footnotes of the financials, or hears that it is surfacing as a practice of

a management team, The Street will very quickly penalize the stock and subtract

credibility points from the CEO.

Such talk arose among several portfolio managers who owned big

chunks of real estate in the form of REITs. They thought this accounting

issue was occurring among tenants and landlords of certain commercial

properties and might become a material revelation. Concerned their stocks

would fall if news of the problem were true, they sent a ripple of warning

out to the companies. The companies now knew that The Street strongly

disagreed with the practice and that there was a chance that valuations

would be adversely affected if the issue came to light.

Obviously, both sides of the business-to-business relationship were vulnerable.

If the landlords in this case had overcharged, then they had overreported

revenue for that period. If the tenants were underreporting the

COGS expense, then they were possibly hiding millions of dollars of gross

margin expense. Both sides were potentially enhancing earnings.

The fact is that in these scenarios, where a business or a division is playing

an accounting game to shore up numbers, the CEO and CFO will be exposed

every time. Wall Street is always checking the notes and assumption

behind COGS and other line items, and management must always acknowledge

it. Though an income statement can be somewhat manipulated,

the discrepancies will always come out in the cash flow statement. To that

end, earnings quality should always be identified by IR and expressed

accordingly.

NOLs: Net operating loss (NOL) carry forwards are one of the

subjects that create confusion among management teams with regard

to communication. Many companies intentionally report and highlight

the untaxed number because of the net operating loss, but fail to mention

the NOL outright because the reported number might not be viewed as very

high after all.

This approach works in management’s favor, until they’ve run out of

the net income sheltering NOLs (when earnings will again be fully taxed).

This fully taxed year will not compare favorably to the untaxed year, and

the company’s year-over-year comparisons will look as if the underlying

business experienced serious erosion when, in reality, pretax net income increased.

Unfortunately, this company put itself in an awkward situation

for a perceived short-term gain, and it all could have been avoided if the

company had presented earnings as pro forma fully taxed despite the untaxed

GAAP number. A simple GAAP-to-pro forma reconciliation would

have kept the communications sound and within the current rules.

Any decent analyst will see the NOLs as temporary anyway, and value

them on a present value basis (because it’s real future cash that the company

can invest over time).

Cash

Cash on the balance sheet can be viewed as positive or negative. A lot of

cash can peg a management team as too conservative, unwilling to undertake

prudent risk. It can also signal a business that legitimately has few reinvestment

opportunities. Therefore, analysts should know that the company

has plans for its cash, whether it be for share repurchasing, dividends, research

and development, or capital spending. After all, the stock market is

about return on investment over and above the bond market, and over and

above the 1 percent or 2 percent that can be generated in savings.

By investing in a new project, a company and investors expect a return

in the form of free cash flow. This, in turn, fuels a perpetual investment cycle

of cash generated from operations being invested in yet higher return projects.

That’s why investment pros look for management teams who can consistently

and over time drive return on equity and return on assets.

If a company is going to redeploy cash to increase shareholder value it

has to consider how each decision affects each type of investor and how the

cumulative action will affect value. The hope is that management is assessing

which alternatives can generate the greatest return on invested capital

for shareholders, and IR’s job is to position the outcome to buy- and sellside

analysts.

Light Bulb Ideas, a consumer electronics company, had just come out of

a cyclical downturn in its core business with a solid balance sheet, lots

of free cash flow, and numerous potential investment opportunities, including

acquisitions. The company recently initiated a dividend in light

of favorable dividend tax legislation.

Light Bulb Ideas had three large institutional shareholders. One

was a growth fund that was urging management to reinvest in the business

aggressively via capital expenditures and acquisition opportunities.

A second fund was a value fund that wanted management to utilize its

growing free cash flow and cash on hand to buy back stock to enhance

returns. A third fund was an income-oriented institution that wanted

management to increase the dividend.

Management posed the question, “What should we do when three

large shareholders are asking for three different things?” After some

(continued)

Similarly, if a company in mid-strategy changes tactics for its cash, it

needs to communicate the story behind that decision. For example, if a company

pulls back a dividend to use the cash for an acquisition, or invests in a

new product development instead of pursuing acquisitions, the effects of

each of these, to each type of investor, must be calculated and quantified.

Management should articulate its strategy and decision making with all

shareholders’ interests in mind.

Debt

Debt requires a continuous search for the lowest cost of capital to support

the optimal return on equity. Although good earnings or excess cash can

be used to pay off debt, companies are often wiser to maintain certain levels

of debt, as debt can be the cheapest money around (particularly in the past

few years).

However, The Street’s perception of different debt levels can have a sigcareful

analysis and in-depth discussions with senior management, an

IR team suggested they do what they have been doing best: run the business.

But they also needed to communicate better to shareholders just

how they were running that business.

To knowledgeable observers, the company seemed overfocused on

what shareholders had to say and factored these cluttered messages into

their decisions. What they should have been sharing with investors,

however, was the rigorous hurdle process they had for committing investor

capital, regardless of growth, value, or income orientation. Their

practice, before any of the company’s capital was ever put at risk, was

to complete a detailed rate of return analysis; managers were held to

performance standards based on that analysis. Before capital was reinvested

in the business or used for an acquisition, those returns were

compared to the benefits to shareholders of a stock buyback or an incremental

dividend.

Not only was this information very important to shareholders, but

it needed to be communicated to them. That information would serve

as the foundation to keep all three shareholder constituencies—growth,

value, and income—satisfied, because they would know that they had

a management team that was already looking out for their best interests

by taking shareholder input into consideration regarding capital

allocation decisions.

nificant effect on valuation. If debt is too low, investors may believe management

is playing it too safe with no pressure to be efficient. If debt is too

high, investors may feel interest payments are too burdensome to bring

much to the bottom line. What Wall Street likes is an optimal capital structure

that includes debt and equity, because the returns for shareholders can

be that much more magnified.

Dollar Sense, a company with a top-notch product offering and business

model in the finance sector, was trading at a heavy discount to its peers. It

was obvious that the company carried a lot of cash on their balance sheet

and had very little inventory, but it also had significant high-yield debt. The

Street saw this as a threat to profitability.

Some IR professionals, on the other hand, saw this as a terrific opportunity.

What we knew was that Dollar Sense had been forced to take this

high-yield debt after two banks consolidated and lumped Dollar Sense’s debt

into a sub-credit group, and Dollar Sense just assumed this was par for the

course. They could recapitalize their debt at a better rate, which seemed like

a terrific communications gem and a catalyst for improved earnings.

The first step was to clear the high cost of capital cloud hanging over

Dollar Sense and tell the story so that The Street would not think that the interest-

coverage threat was as real as the debt levels would suggest.

Once articulated, via a conference call, investors and analysts clearly realized

that the high cost of debt was not a liability to equity holders. Rather,

the debt was a catalyst for improved earnings because once the capital markets

realized that the company was now going to actively refinance this debt,

the cost of capital would eventually go down and there would be a financial

bump to earnings. In addition, the refinancing opportunity also was a “public

broadcast” that the company would recognize prepayment penalties, so

no investor would be surprised when it actually occurred.

By reconciling the balance sheet to the overall growth story we shifted a

perceived weakness into a strength. A strong company was signaling that it

was going to recapitalize, the bankers smelled opportunity to garner a client,

and the sell-side became further engaged. IR from a capital markets perspective

knew how to make the most of this information, attract bankers,

and position the company for enhanced visibility.

HORIZON THINKING

Ultimately, the stock market may overreact, either positively or negatively,

to any of the events or conditions we’ve mentioned in this chapter. But if the

company believes that the underlying financial outlook hasn’t changed, then

the short-term consequences of these overreactions shouldn’t be an urgent

matter. Stock prices don’t stay up or down forever, so if the company is confident

in the future, it should simply reposition relative to its peers, understand

that one investor’s weakness is another’s buying opportunity, and rely

on IR strategy to re-engage the market, albeit at a lower valuation. With the

proper guidance, the price will recover, assuming the financial results match

expectations.

As part of the Dialogue stage, IR must react appropriately to positive and

negative events, in order to enhance or preserve valuation at any given

time. To best anticipate and negotiate the inevitable, IR must (a) always have

the proper information available in the form of market data and market

feedback, (b) have a relationship with the CEO based on respect so that

management can absorb and take direction from IR depending on the circumstances,

and (c) help management plan its short- and long-term strategies

with an understanding of the potential effects on the market.

INFORMATION FLOW

In order to make an informed decision based on unexpected events, IR must

have the proper information available at all times. For internal IR at a larger

company, this means subscribing directly to third-party information vendors.

A smaller company can depend on agencies for these services. In addition

to the important real-time data, IR must also gather investor perception

and feedback, and combining the two should make any tough decision that

much easier.

Third-Party Information Systems

In order to monitor the markets and the unexpected events that invariably

occur, IR must have access to the following:

Stock quotes: Not only the company’s day-to-day stock price movements,

but its peer group’s. This is the first line of defense in keeping an

eye on market perception of an individual company or group.

First Call: A company can gauge the effectiveness of its message and

guidance by checking analyst research and recommendations and, of

course, the First Call earnings estimates. IR should also gather research

reports on competitors and the sector, and process any new information

that surfaces.

Trading: The Autex Rankings gather trading volume in stocks by investment

bank and shows which banks are active in any particular stock

at any given time. These figures can be an indicator of company or sector

expertise, or the banks’ willingness to commit capital on the trading

desk.

Ownership: IR needs to extract, from shareholder databases, a list of

the new owners, existing owners who have added to their positions, and

those who have sold their stock. This is mandatory when performing a

cross-ownership analysis for targeting, particularly when a stock is

dropping.

Conference call transcripts: Transcripts are the best way to track material

events in the industry.

IR should package this information for management, so they can

glimpse a quarterly scorecard of sorts and form an idea of how the company

is being perceived against its peers.

Garnering Feedback

Part of that packaged information should also include old-fashioned buyand

sell-side feedback. This information, in the form of informal conversations,

estimate revisions or recommendation changes, or the actual buying

or selling of stock, is the purest form of judgment. But feedback sometimes

can be tough to find.

Analysts

In terms of the sell-side, even a 15-minute conversation during earnings season

can be asking a lot, so IR must come across as an informed peer who can

talk credibly about valuation and industry events. Also, if IR can be a gatekeeper

to a deeper relationship with management, that will also earn respect.

Ultimately, IR must use whatever leverage it has to engage the analyst and

extract the market’s current perception. An inexperienced subordinate, with

a checklist list of questions will almost always be ineffective.

Investors

Investors purchase stocks because they believe the financial outlook is positive

relative to the current price, and they sell stocks when they believe the

opposite is true.

Investors with large stakes in companies have a particular interest that

the company do well financially, and this objective gives IR an opportunity

to reach into the thought processes of the buy-side and garner any

perception that’s relevant, such as the investment highlights as the PM

sees them.

Information from an institution that has not purchased stock in the

company, but is buying the competition, is equally valuable to IR. Obtaining

this investor’s insights can lead to uniquely helpful and constructive criticism.

These are tough-to-access, unique opinions because the investor is obviously

interested and bullish on the sector, but has some reservations about

the company in question. Perhaps the investor is harboring reservations

about the success of the business or even skepticism about management.

Short Sellers

Similarly, IR should always be aware of short interest and why certain investors

are betting that the company won’t live up to expectations. Although

short sellers are tough investors for IR to pin down directly, even

the second-hand story can give management the ammunition to prepare a

counter argument.

Wall Street’s Hot Buttons

In any given sector at any given time, companies are doing business and generating

news. Because the stock market moves on how that news might affect

financial performance, it’s safe to say that there is always something to

react to in the IR department. Examples are foreign exchange rates, a pending

port strike, back to school’s shaping of inventory levels, a shift in demographics,

a thrust in teen spending, or the overcrowding of a market that

stalls expansion and suppresses growth. IR should always be prepared to tailor

dialogue based on the issues affecting the company’s sector.

This awareness is especially important when drafting the conference call

script and deciding which issues require emphasis or even inclusion.

Another method of handling unforeseen events is to launch a pre-emptive

strike and take control of the information. Tread Lightly, a footwear manufacturer, had a large amount of its business flowing through one retailer.

Thanks to Regulation FD, companies can’t disclose anything to The

Street that IR professionals can’t also access.

The IR community discovered that the retailer was receiving certain exclusive

agreements from a competitor, Putya Foot Down. We knew that the

retailer was not receiving any such agreements from Tread Lightly, and that

these agreements would give the retailer incentive to feature Putya Foot

Down products to shoppers with price reductions and special displays. This

would, of course, hurt Tread Lightly’s volume and presumably its stock

price.

Given that the retailer was Tread Lightly’s biggest customer, investors

and analysts would estimate a drop in sales. Tread Lightly’s IR advisors had

the company consider this possibility before The Street did so that they

could reconcile it with their strategy, make adjustments, and address the

issue with the investment community.

Another reason to stay on top of industry events is to draft off of others’

momentum. A company had recently licensed a hot brand for one of its

product lines. IR heard from The Street that a huge retailer was touting this

particular brand, cheering its recent volume in its stores. The opportunity Swell Sweaters Inc. and Sophisticated Shirts Corp., two companies in

the clothing industry, were trading at similar multiples. Then Swell

Sweaters started doing very well based on an emerging sports trend

while Sophisticated Shirts was pulled down by a portfolio that, by contrast,

seemed outdated.

Timeless Tops also competed in this sector. They had the preppy

image as well, but their value and quality stayed popular with teens.

Yet, Timeless Tops’ stock was trading at a discount, and IR’s information

(stock performance, First Call, shareholder analysis) pointed to the

fact that the preppy image was probably the reason.

IR wasn’t sure, though, and reached out to The Street for reconnaissance.

After talks with several portfolio managers, IR found, instead,

that the concern was low inventory and faltering sales. This news

was delivered back to Timeless Tops and a strategy emerged.

Their next communication to The Street immediately addressed

these issues and articulated current initiatives as part of the company’s

strategy. The misperception was corrected, but without the proper information,

handling this event would have been impossible.

arose for the company to capitalize on the buzz and start communicating its

success with the brand but in a context that included conservative guidance.

This easy, quick maneuver gained significant IR and PR attention, positioning

the company to exceed estimates and create long-term value.

Analysts and investors see many companies fail to stay in touch with

trends that affect valuation within their own sector. IR needs to remain diligent

for management, collect the information, interpret it, and determine

what course is best to maximize valuation.

If IR doesn’t already know the sector’s overarching messages each quarter,

it’s bound to discover them too late. Anticipating these hot buttons keeps

the company ahead of the audience.

THE IR/CEO RELATIONSHIP

The most crucial element for productive dialogue with The Street is the management/

IR relationship. IR must be an effective and reliable liaison between

The Street and the company, and the CEO must believe that IR lends him or

her a new perspective. Too many yes-men around the CEO can be awful for

shareholders, but sometimes a domineering CEO has no interest in hearing

critical feedback. The role of the IRO or the outside IR counsel is to bridge

the gap between the company and the capital markets, stand up to the CEO

when no one else will, and bring Wall Street’s perspective to the discussion.

The Emperor Has No Clothes

For IR to be effective, management and the board of directors must trust the

function and give IR full immunity to create a secure conduit to and from

The Street. Given the fact that access is king on Wall Street, and criticizing a

CEO jeopardizes that access, some management teams become insulated

from reality, particularly when the CEO’s ego is an issue. This situation demands

a strong, objective hand to come in for a reality check.

In 2002, a fairly new, but very successful technology company saw its

products gathering momentum. As a result of its success, the company publicly

set high financial goals, which seemed set to garner a high short-term

valuation. Subsequently, executives felt pressure to meet those goals and

were trapped in a make-the-number pattern that crushed so many companies

at that time.

Management, as well as IR, failed this company in several respects.

There was no managing of expectations, guidance was aggressive, short-term

Bankers came to management with a few solutions. One suggested

that Paperclip consider an acquisition to build the business. Another

thought that management should refinance the bank debt with an issue

of high-yield bonds. Yet another suggested selling the company.

An IR audit included a discussion with the buy- and sell-sides. Both

analysts and investors felt that management had an antagonistic attitude

toward the capital markets and was unwilling to listen to feedback,

often fighting back when analysts shared criticism or shutting off

investors who had complaints. The Street also felt that quarter after

quarter, the company would hold back bad news, even when they knew

they were going to hit unexpected, one-time charges that would cause

the earnings to fall short.

This management team was fighting the entire credibility checklist.

Within the company there was no accountability, the numbers were not

transparent, the managers didn’t anticipate problems, and they were

hardly visible to The Street. The Street didn’t care what the value

proposition was, because management had no standing with the investment

community.

IR brought the information back to management. The good news

was that The Street felt Paperclip’s stock could be very attractive if

management pulled its act together. The bad news was that management’s

lack of credibility had sunk the valuation to such depths that

each of the capitalization maneuvers they were considering offered only

symptomatic relief; none, even selling the company, would bring the

shareholders the value that the board felt was appropriate.

Paperclip needed to reposition its story and regain Wall Street’s

trust. IR suggested making the following changes and communicating

them on the next conference call:

Change the tone of all communications from defensive and arrogant

to conciliatory.

Streamline the profile to reflect a simple, organized business model.

Organize an internal audit to create department-by-department accountability.

Direct valuations to focus on EBITDA, not earnings.

Begin cost-cutting initiatives.

(continued)

Other credibility cases don’t turn out as well. Inevitably, despite the best

strategies, negative opinions surface. Because a lot of money is on the line

when analysts make a positive or a negative recommendation, they are very

careful in their assessment of management and in their valuation argument.

One thing that some management teams fail to recognize, however, is

that nothing personal is involved in the process. It’s simply an opinion based

on assumption. Companies that fail to understand this and publicly antagonize

analysts simply end up looking foolish, demonstrating a lack of capital

markets savvy and, ultimately, hurting shareholders.

Executives must find a way to absorb negative opinions and not get into

a defensive volley with analysts, although it happens frequently. Several instances

of management-analyst antagonism have occurred in the past few

years. According to a June 19, 2003, article in The Wall Street Journal, after

two Morgan Stanley analysts questioned Qwest Communications’ accounting,

Qwest denied analyst access to Morgan Stanley and wouldn’t consider

the firm for banking business. The Journal also stated that a former chief executive

“publicly derided the analysts and questioned the integrity of their

work.” Morgan Stanley continued to downgrade the stock to a Sell rating.

The Journal article also reported on a telecommunications analyst at J.P.

Morgan Chase who questioned whether Nextel Communications was lowballing

its bad debt estimates. Within hours, the Journal said, Nextel’s CFO

was on the phone to the analyst’s boss, “accusing the analyst of faulty work.”

In these situations, the companies looked foolish, management lost credibility,

and the shareholders suffered because the stocks dropped. IR with an

understanding of the research process could have headed off this antagonism

and subsequent damage to valuation.

Ultimately, if a company wants to be public and benefit from raising

capital and selling shares, CEOs and CFOs have to understand Wall Street

and also accept the negatives.

Each of these moves sent a signal to The Street that Paperclip’s

management team was accountable, transparent, credible, and candid.

The bankers stepped back and investors stayed with the stock or became

newly involved.

This company had a good business, a good story, and a good plan.

IR helped them adapt short-term goals that would stay true to the longterm

strategy and keep the company honest with The Street. The dissemination

of this story to The Street gained the company increased

coverage and new sell-side distribution and buy-side volume.

Being Upfront with Information

Human nature is to want to position any event in the best light possible, but

analysts are skeptical about promotion. Using superlatives that generate

high expectations puts more risk in the public domain than most analysts or

investors are willing to tolerate; more often than not, analysts and the buyside

steer clear of a heavily promoted stock. For that reason, any company

that tries to spin an obviously negative event into something positive will be

found out in due time. Management credibility and company valuation will

be erased.

HANDLING BAD EVENTS (AND LOWERING GUIDANCE)

Three basics apply to IR’s handling of bad events: don’t delay, don’t divide,

and don’t diminish.

1. Don’t delay: Management should weigh the benefits against the risk of

being one of the last companies in an industry to report. If a material

event occurs and there are risks of rumors in the marketplace, management

wants investors to hear the news from them first. It’s far better to

take control of the situation and define the problem rather than sitting

on bad news and allowing rumors to define the company’s reality. Management

should get a handle on what the news means to the bottom line

and deliver it.

2. Don’t divide: Telling the whole story to all constituents at once helps

 “One of the most important things a CFO must do is articulately communicate

what is going on in the company to outside constituents and

do it with credibility. That’s always been important, but it’s even more

so today.

—David Viniar, CFO, Goldman Sachs

“You get no pretense with David. He’s the opposite of slick. In evaluating

a complex company that takes on a lot of risk, like Goldman,

that makes me comfortable,”

—anonymous investor on David Viniar.

Source: February 2004 Institutional Investor

take the risk out of the news, even if it’s bad. Ideally, management

should never allow another shoe to drop. If bad news does dribble out,

the analyst has no choice but to negatively comment on every announcement.

This painful, drawn-out process will affect future earnings

and the stock’s multiple will likely compress.

A slow roll-out of bad news has a ripple effect as the media latches

on to the problems, and as employees and vendors lose confidence in

management. These factors can fundamentally weaken the business,

leading to a low valuation and a high cost of capital.

Companies need to get all bad news out at once if possible. Explain

it, quantify it, boil it down to conservative earnings guidance, and rebuild

the share base through effective targeting.

3. Don’t diminish: Management must be transparent and accountable

because analysts ultimately listen to management teams that own up

to mistakes. They don’t want to hear excuses that downplay the

news.

We knew a company that treated earnings releases as an opportunity to

promote the business. They glossed over financial results in favor of promotional

language that always cast the business in the best light. The fact was,

management was viewed poorly by The Street despite their chronically rosy

outlook that attempted to perpetually mask poor earnings. That game can

be played only so many times without investors running for the exits. In fact,

they did.

Another often-used excuse is blaming poor earnings on events outside of

management’s control, such as the economy, weather, or our recent favorite,

“geopolitical issues.” This type of deflection, although sometimes very true,

can often be a management crutch. One company had for several quarters

had been blaming sub-par performance on the economy. At the same time

industry peers were announcing positive results in those same markets due

to a rebounding economy. IR’s job is to monitor competitor results because,

as in this case, it can avoid embarrassment. Had management blamed the

economy again when others were doing well, credibility would have been

further damaged. This is just another example of a proactive IR effort managing

an unexpected event.

THE OPTIMAL TIME TO LOWER GUIDANCE

One of the most important events that a management team faces is lowering

guidance. In determining the best time to do so, IR should take into account

stock price and valuation. That check can be the difference between the

stock getting trounced and the stock increasing on high volume.

If the stock price is at a 52-week low, the valuation is at a big discount

to its peer group, and the analyst community is relatively disengaged—that

is, no one has a Strong Buy rating—management has greater leeway to reduce

guidance without hurting the analyst, the investor, or its own credibility.

In all likelihood The Street is expecting very little from management performance-

wise given this scenario, and the market might just be waiting for

management to reassess its expected earnings guidance. Bringing guidance

down under these circumstances would result in lower risk, more attention,

and probably an increased stock price.

However, if the valuation is high—say, because the CEO wanted to use

25 percent EPS guidance rather than 15 percent as the IRO suggested—management

must take its medicine and lower expectations. To minimize the

risk, the company should do this after the market closes in a press release

with a simultaneous conference call to explain the factors. This is the best

way to lessen the risk of a situation that management and IR both know will

result in a falling stock price.

When readjusting guidance, management cannot be married to a bestcase

number. In fact, given the choice of lowering a $1.10 estimate by $0.05

or $0.10, management should always take the latter, particularly if the stock

is drifting downward. The reason is that another $0.05 reduction isn’t going

to matter as much to The Street as if the company positions itself to miss revised

guidance. Additionally, when setting guidance, management must do

so with an eye to the future. Most events are usually not a one-quarter phenomenon,

and The Street will suspect that subsequent quarters may come in

low. When the company sets guidance, it needs to establish a conservative

cushion for the rest of the year, without, of course, setting itself up to materially

exceed the number either. To set the company up for success, guidance

must be both realistic and achievable.

HANDLING GOOD EVENTS

One quarter after another of terrific results is every company’s dream, but

this is where IR hits the double diamond trails of keeping a check on management

ego and managing The Street’s expectations. In order to stay on

course and not be dissuaded by the stock price, IR must script a bit of conservatism

or push back in every quarter when there is great success. Management

must always be in control of its numbers via guidance, and an analyst

or two over-hyping the company is an analyst or two too many.

Another by-product of positive news is the invariable analyst downgrade.

As mentioned throughout this book, analysts are in the business of

generating commissions; therefore, a large part of their job is to upgrade and

downgrade stocks. In theory, this activity guides the decisions of the buy-side

and in the process drives trading volumes for the investment bank.

The analyst downgrade should never be taken personally, and CEOs

should understand that when his or her stock price reaches the analyst target,

action will be taken. Either the analyst will up the price target and reiterate

her Buy rating or downgrade the stock, saying it’s fully valued.

IR’s task, through conservative guidance primarily, is to manage expectations

to the point where the company has built significant credibility. At

that point, an analyst typically downgrades based on valuation only. In

other words, the analyst isn’t lowering his rating because the business model

is flawed or because management has lost credibility. He is lowering is because

the stock hit the target price.

This downgrade is the best that a company can hope for, and it might

read something like this:

Analyst Paul Hewson from American Securities writes, “Based solely on

valuation, we are lowering our rating to Underperform from Marketperform.

We continue to view this as a good company that has met or

exceeded our expectations. However, with the sharp run-up in share

price, we believe the stock is considerably ahead of current expectations.

Victory’s stock has appreciated by more than 40% in the last couple of

months, from the mid-teens to more than $20 per share. Our 12 month

price target remains unchanged.”

Again, managing the analyst community relative to good news is just as

important as doing so when the news is bad. Because the buy-side pays more

attention to the content of any report versus the rating, a downgrade such as

the one above is a big victory for the company and IR.

How does a company control investor expectations when the business is

on fire? An article in The Wall Street Journal, March 25, 2004, was titled

“Investors Cut Starbucks Some Rare Slack.” With the subhead, “Coffee

Chain’s Decade of Frothy Performance Overshadows Chairman’s Growth

Warning.”

The article states: “When a top executive warns investors that his company

won’t be able to sustain its rate of growth, the result is usually a stock

sell off. But that didn’t happen on Feb. 25th when Howard Shultz, chairman

of Starbucks Corp., announced that the world’s largest chain of coffee shops

couldn’t keep getting larger at rates as fast as 32%. Sure the stock slipped,

but only 3.4%, and then it bounced back a day or two, perhaps because the

company nevertheless stood by double-digit sales-growth expectations. As

for analysts, their recommendations remained neutral or positive, with most

of them predicting that Starbucks would outperform the market. This faith

in Starbucks certainly doesn’t arise from any sense that the stock is undervalued.

In recent days, the price-to-earnings ratio of Starbucks stock has

flirted with 50, making it one of the most expensive stocks on Wall Street.”

. . . “Rather, the market reaction—or lack of reaction—suggests that a rare

type of credibility gap is developing between Starbucks and the Street. It is

the opposite of the gap that forms between hype-prone executives and shareholders.

This type of gap reflects no suspicion, no sense among investors that

the executive is trying to fool them or gin up a quick bump in the stock; instead,

there’s a sense that this executive is hard on himself and his company,

and therefore his self-effacement isn’t entirely credible.” The article compares

this credibility gap with that developed around Warren Buffett and the

late Sam Walton.

This approach to restraining, or at least trying to restrain, The Street allows

management to focus on the business and The Street to worry about

valuation.

MANAGEMENT AND LANGUAGE

One of the most important parts of a company’s ongoing dialogue with The

Street is the actual language that’s used on a day-to-day basis. To that end,

management and IR shouldn’t underestimate the impact of the words they

use. For example, if a CEO is asked how he feels about his company’s most

recent guidance and starts his answer with the phrase, “Several things have

to happen for us to deliver . . . ,” investors might sell a share or two.

In order to script and oversee a conservative communication’s plan, IR

has to make sure that all language is tempered and delivered in terms that

The Street is used to hearing. A company should never say emphatically that

“we will,” but rather “we believe,” “we should,” or “we expect.”

Nor can the language be nebulous. A company which states that they

are going to “make a significant investment in cap ex” or “generate substantial

earnings potential” without quantifying such terms is giving openended

guidance, which is dangerous. Analysts and investors must translate

words to numbers or any number of variations could come out of those

phrases. For example, “substantial earnings potential” from a new initiative

might mean 5 cents in one analyst’s model and 15 cents in another analyst’s

model. The result would be a wide-ranging, higher than intended, First Call

consensus estimate that management, deep down, knows is unattainable.

Words, whether referring to guidance or when issuing new news, should always

be quantified, with an earnings per share range and a time frame that

foots with that financial guidance.

Words are just the beginning. As we mentioned earlier, in the late summer

of 2003, the SEC cited a Reg FD violation based on “tone, emphasis

and demeanor” to Schering-Plough. The IRO was present at the time of

the infraction, which illuminates the fact that even some of biggest IR executives

can’t be expert enough on the ever-changing regulations on financial

disclosure. Staying within the limits of the right words and phrases,

not to mention the appropriate body language is not easy. That’s what

makes systematic, scripted disclosure, with clear and quantifiable guidance,

essential.

Finally, it’s also helpful in the Dialogue stage if everyone is speaking the

same language.

Big Hand Accessories, a consumer products company, kept telling The

Street that their business wasn’t seasonal, and that, in fact, the reason

the company was so profitable was because it was not seasonal, which

was confusing to IR consultants who worked with them. Their accessories

clearly sold better in summer than winter.

When we asked the CEO about this, he explained that when they

were not selling in North America, they were selling in Australia at a

different time of year. He was quite surprised when we told him that by

using the word “seasonal,” not only was he not clearly explaining the

situation, but he was creating the impression that he didn’t understand

it either.

Curious that this didn’t come up in calls, the IR team asked some

of the analysts and investors why they had never questioned the CEO

on his use of this word. They said that they thought that they were

missing something obvious and they were waiting to figure it out before

asking.

IR decided to clear this up and scripted the next call to do just that.

In the call, the CEO explained that the business adapts to the market

with less SKUs by creating products that avoid obsolescence because

they transfer easily.

That solved that problem.

THE MARKET EFFECTS OF SHORT- AND

LONG-TERM STRATEGIES

On a quarter-to-quarter basis, P&L and balance sheet items change with financial

performance, and each change is another event that must be properly

explained to Wall Street. Although this book certainly couldn’t address

every possible variation, in most situations strategic IR is able to clarify the

issues and communicate them properly.

State of Affairs and Their Effects

LIFO, FIFO: Inventory levels send strong signals to The Street and may be

misinterpreted if they’re not backed by a logical story. For example, slower

inventory turns can sometimes foretell an earnings slowdown, or a retailer

may experience inventory levels that appear higher than sales can sustain.

In many industries, inventory levels and turns are cyclical, but sometimes

they indicate a particular shift in the marketplace. This situation can

be specific to a particular company, because of something that’s happened to

its product or service or those of its competitors. Or the situation can be specific

to the industry, like a shift in demographics or the economy that affects

buying tendencies or consumer tastes.

Investors that smell an inventory problem on the balance sheet may

be prompted to sell shares. But if the company has the chance to explain

that these inventory levels are built into the projections for, let’s say, new

stores coming on line, a shifting marketplace, or a proven strategy, the investors

will see a viable asset, one that will be monetized and benefit the bottom

line.

A/R and COGS: There are times when expenses, specifically cost of

goods sold (COGS), are contested. This can happen when companies do not

believe that they owe their suppliers or vendors certain expenses or that they

were overcharged for expenses that are directly related to the cost of making

the products they sell.

Some companies, when they contest this number, may assume they are

either not going to have to pay the contested amount or that they are going

to get a refund on payments already made. Then they don’t even recognize

this expense as a cost at all, deleting it altogether from COGS. Those who

expect a refund may go so far as to book it as a receivable. This type of expense

refuting or refund claim inflates earnings. If Wall Street sees this tactic

in the footnotes of the financials, or hears that it is surfacing as a practice of

a management team, The Street will very quickly penalize the stock and subtract

credibility points from the CEO.

Such talk arose among several portfolio managers who owned big

chunks of real estate in the form of REITs. They thought this accounting

issue was occurring among tenants and landlords of certain commercial

properties and might become a material revelation. Concerned their stocks

would fall if news of the problem were true, they sent a ripple of warning

out to the companies. The companies now knew that The Street strongly

disagreed with the practice and that there was a chance that valuations

would be adversely affected if the issue came to light.

Obviously, both sides of the business-to-business relationship were vulnerable.

If the landlords in this case had overcharged, then they had overreported

revenue for that period. If the tenants were underreporting the

COGS expense, then they were possibly hiding millions of dollars of gross

margin expense. Both sides were potentially enhancing earnings.

The fact is that in these scenarios, where a business or a division is playing

an accounting game to shore up numbers, the CEO and CFO will be exposed

every time. Wall Street is always checking the notes and assumption

behind COGS and other line items, and management must always acknowledge

it. Though an income statement can be somewhat manipulated,

the discrepancies will always come out in the cash flow statement. To that

end, earnings quality should always be identified by IR and expressed

accordingly.

NOLs: Net operating loss (NOL) carry forwards are one of the

subjects that create confusion among management teams with regard

to communication. Many companies intentionally report and highlight

the untaxed number because of the net operating loss, but fail to mention

the NOL outright because the reported number might not be viewed as very

high after all.

This approach works in management’s favor, until they’ve run out of

the net income sheltering NOLs (when earnings will again be fully taxed).

This fully taxed year will not compare favorably to the untaxed year, and

the company’s year-over-year comparisons will look as if the underlying

business experienced serious erosion when, in reality, pretax net income increased.

Unfortunately, this company put itself in an awkward situation

for a perceived short-term gain, and it all could have been avoided if the

company had presented earnings as pro forma fully taxed despite the untaxed

GAAP number. A simple GAAP-to-pro forma reconciliation would

have kept the communications sound and within the current rules.

Any decent analyst will see the NOLs as temporary anyway, and value

them on a present value basis (because it’s real future cash that the company

can invest over time).

Cash

Cash on the balance sheet can be viewed as positive or negative. A lot of

cash can peg a management team as too conservative, unwilling to undertake

prudent risk. It can also signal a business that legitimately has few reinvestment

opportunities. Therefore, analysts should know that the company

has plans for its cash, whether it be for share repurchasing, dividends, research

and development, or capital spending. After all, the stock market is

about return on investment over and above the bond market, and over and

above the 1 percent or 2 percent that can be generated in savings.

By investing in a new project, a company and investors expect a return

in the form of free cash flow. This, in turn, fuels a perpetual investment cycle

of cash generated from operations being invested in yet higher return projects.

That’s why investment pros look for management teams who can consistently

and over time drive return on equity and return on assets.

If a company is going to redeploy cash to increase shareholder value it

has to consider how each decision affects each type of investor and how the

cumulative action will affect value. The hope is that management is assessing

which alternatives can generate the greatest return on invested capital

for shareholders, and IR’s job is to position the outcome to buy- and sellside

analysts.

Light Bulb Ideas, a consumer electronics company, had just come out of

a cyclical downturn in its core business with a solid balance sheet, lots

of free cash flow, and numerous potential investment opportunities, including

acquisitions. The company recently initiated a dividend in light

of favorable dividend tax legislation.

Light Bulb Ideas had three large institutional shareholders. One

was a growth fund that was urging management to reinvest in the business

aggressively via capital expenditures and acquisition opportunities.

A second fund was a value fund that wanted management to utilize its

growing free cash flow and cash on hand to buy back stock to enhance

returns. A third fund was an income-oriented institution that wanted

management to increase the dividend.

Management posed the question, “What should we do when three

large shareholders are asking for three different things?” After some

(continued)

Similarly, if a company in mid-strategy changes tactics for its cash, it

needs to communicate the story behind that decision. For example, if a company

pulls back a dividend to use the cash for an acquisition, or invests in a

new product development instead of pursuing acquisitions, the effects of

each of these, to each type of investor, must be calculated and quantified.

Management should articulate its strategy and decision making with all

shareholders’ interests in mind.

Debt

Debt requires a continuous search for the lowest cost of capital to support

the optimal return on equity. Although good earnings or excess cash can

be used to pay off debt, companies are often wiser to maintain certain levels

of debt, as debt can be the cheapest money around (particularly in the past

few years).

However, The Street’s perception of different debt levels can have a sigcareful

analysis and in-depth discussions with senior management, an

IR team suggested they do what they have been doing best: run the business.

But they also needed to communicate better to shareholders just

how they were running that business.

To knowledgeable observers, the company seemed overfocused on

what shareholders had to say and factored these cluttered messages into

their decisions. What they should have been sharing with investors,

however, was the rigorous hurdle process they had for committing investor

capital, regardless of growth, value, or income orientation. Their

practice, before any of the company’s capital was ever put at risk, was

to complete a detailed rate of return analysis; managers were held to

performance standards based on that analysis. Before capital was reinvested

in the business or used for an acquisition, those returns were

compared to the benefits to shareholders of a stock buyback or an incremental

dividend.

Not only was this information very important to shareholders, but

it needed to be communicated to them. That information would serve

as the foundation to keep all three shareholder constituencies—growth,

value, and income—satisfied, because they would know that they had

a management team that was already looking out for their best interests

by taking shareholder input into consideration regarding capital

allocation decisions.

nificant effect on valuation. If debt is too low, investors may believe management

is playing it too safe with no pressure to be efficient. If debt is too

high, investors may feel interest payments are too burdensome to bring

much to the bottom line. What Wall Street likes is an optimal capital structure

that includes debt and equity, because the returns for shareholders can

be that much more magnified.

Dollar Sense, a company with a top-notch product offering and business

model in the finance sector, was trading at a heavy discount to its peers. It

was obvious that the company carried a lot of cash on their balance sheet

and had very little inventory, but it also had significant high-yield debt. The

Street saw this as a threat to profitability.

Some IR professionals, on the other hand, saw this as a terrific opportunity.

What we knew was that Dollar Sense had been forced to take this

high-yield debt after two banks consolidated and lumped Dollar Sense’s debt

into a sub-credit group, and Dollar Sense just assumed this was par for the

course. They could recapitalize their debt at a better rate, which seemed like

a terrific communications gem and a catalyst for improved earnings.

The first step was to clear the high cost of capital cloud hanging over

Dollar Sense and tell the story so that The Street would not think that the interest-

coverage threat was as real as the debt levels would suggest.

Once articulated, via a conference call, investors and analysts clearly realized

that the high cost of debt was not a liability to equity holders. Rather,

the debt was a catalyst for improved earnings because once the capital markets

realized that the company was now going to actively refinance this debt,

the cost of capital would eventually go down and there would be a financial

bump to earnings. In addition, the refinancing opportunity also was a “public

broadcast” that the company would recognize prepayment penalties, so

no investor would be surprised when it actually occurred.

By reconciling the balance sheet to the overall growth story we shifted a

perceived weakness into a strength. A strong company was signaling that it

was going to recapitalize, the bankers smelled opportunity to garner a client,

and the sell-side became further engaged. IR from a capital markets perspective

knew how to make the most of this information, attract bankers,

and position the company for enhanced visibility.

HORIZON THINKING

Ultimately, the stock market may overreact, either positively or negatively,

to any of the events or conditions we’ve mentioned in this chapter. But if the

company believes that the underlying financial outlook hasn’t changed, then

the short-term consequences of these overreactions shouldn’t be an urgent

matter. Stock prices don’t stay up or down forever, so if the company is confident

in the future, it should simply reposition relative to its peers, understand

that one investor’s weakness is another’s buying opportunity, and rely

on IR strategy to re-engage the market, albeit at a lower valuation. With the

proper guidance, the price will recover, assuming the financial results match

expectations.