Markets & Finance

Earnings Guidance: The Price of Silence


S&P equity analysts weigh in on quarterly guidance - and what investors need to know about it

From Standard & Poor's Equity ResearchThe second-quarter earnings reporting season officially kicks off on July 9, when Alcoa (AA; $39; 2 STARS, sell) reports. And what kind of profit might investors expect from the aluminum giant? Don't ask Alcoa; the company does not provide earnings estimates.

And it's not the only one. More and more companies are opting out of that practice.

Companies that do not provide profit guidance include AT&T (T; $41; 3 STARS, hold), Berkshire Hathaway (BRK.A; $108; 3 STARS), Coca-Cola (KO; $53; 4 STARS, buy), Constellation Brands (STZ; $25; 3 STARS) Goldman Sachs (GS; $220; 5 STARS, strong buy), Google (GOOG; $24; 3 STARS), IAC/InterActiveCorp (IACI; $35; 4 STARS), McDonald's (MCD; $51; 5 STARS), and Toll Brothers (TOL; $25; 3 STARS).

Why is this the case?

"In many cases, the visibility is so low, company management is not comfortable with giving guidance," says Steve Biggar, director of U.S. equity research for Standard & Poor's. "That's going to be a negative from an analyst perspective because it removes a level of comfort in the benchmarking."

Biggar notes well-established firms that should have a strong sense of quarterly earnings stats are also omitting forecasts.

"They may not want to disappoint investors," he explains.

Barry Diller's IAC/InterActiveCorp is a good example.

"A few years ago at a widely attended analyst meeting, the company provided what I recall were specific financial goals," says Scott Kessler, head of technology equity analysis at S&P. "Then, a number of months later, the company indicated it wasn't necessarily going to meet those targets, and the stock sold off considerably. The company indicated those goals didn't constitute guidance, but the investing public construed things differently. Since then, IAC hasn't provided guidance." In the year after it stopped offering forecasts, IAC performed quite well, though it has underperformed so far this year.

An academic study looked at the links between the lack of earnings guidance and stock performance. The researchers studied the period after Regulation Fair Disclosure went into effect in October, 2000.

According to researchers, who studied 75 companies from October, 2000, to October, 2004, companies that stop giving guidance have poor trailing earnings and stock return performance. However, according to the study from the University of Washington, "Is Silence Golden? An Empirical Analysis of Firms that Stop Giving Quarterly Earnings Guidance," there is some evidence that eliminating estimates results in less volatile stock returns, which the authors say is "consistent with the idea that guidance is not as necessary when performance is relatively stable and predictable."

The study also found Wall Street analysts did a worse job of predicting quarterly earnings stats for companies that stopped providing guidance.

"Don't blame the Street! Company managements have let earnings guidance become an end data point, rather than a support point within a larger conversation about their company's long-term goals," says Kevin Kirkeby, an S&P equity analyst. "Guidance is meant to provide a degree of comfort that near-term metrics are tracking as they should and that management has been realistic in its discussions with the Street about what it is doing and where it wants to take the company. Quarterly per-share earnings guidance alone is not enough. It encourages analysts to focus on a single number and one that often deviates substantially from things occurring at the operating level. Companies - and analysts - need to emphasize factors impacting revenues and margins."

While examples akin to IAC's abound - a major selloff after an earnings "miss" - the opposite is also true; many companies guide conservatively so they can "beat" estimates, which often turns into a short-term stock price boon.

While it is impossible to accurately predict which companies will beat expectations in the coming earnings reporting season, The Outlook polled S&P equity analysts for their thoughts on those that regularly seem to do so.

Two of companies are highlighted here. There is no guarantee either of them will beat second-quarter estimates, nor is there any guarantee there will be a subsequent stock price uptick. But both are ranked 5 STARS, suggesting S&P analysts believe they will outperform in the next 12 months.

GOLDMAN SACHS

S&P Quality Rank: NR

The investment bank's prospects are closely tied to global economic growth and can be highly volatile quarter-to-quarter. As such, the company, like its peers, does not provide any type of earnings forecasts.

We expect Goldman Sachs to continue to benefit from record levels of investment banking activity, and a recent increase in volatility should aid equity and fixed-income capital markets results.

We look for Goldman to earn $21.61 a share in fiscal 2007 (ending November), which would be an improvement of 10% over the prior year's results. A peer-level multiple of 12.5 was applied to our earnings projection to reach our 12-month target price of $270.

The shares yield 0.6%. We strongly recommend purchase.

MICROSOFT

S&P Quality Rank: B+

The software giant introduced a new operating system, Vista, earlier this year. We believe consumers' adoption of Windows Vista has been better-than-expected. Sales could accelerate in the first half of 2008 when the company releases Windows Server 2008, which will enable enterprises to upgrade to the latest versions of Office, Vista, and back office simultaneously.

IDC, a technology research firm, recently raised its 2007 worldwide PC shipment growth rate estimate to 12.2% from 11.1%.

Overall, we forecast total revenue for the company will increase more than 11% in fiscal 2008 (ending June). We expect per-share profits to rise 15%, reflecting an expanding operating margin and lower shares outstanding due to the company's share purchase program.

Our 12-month target price of $35 is about 20 times our fiscal 2008 earnings estimate. The valuation is in line with the stock's peer group of enterprise software despite the company's market leadership position and our view of higher near-term growth prospects due to an upgrade product cycle. We recommend purchase of the shares, which yield 1.3%.


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