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The Wall Street Journal: Numbers Game: Why ‘Guidance’ May Not Matter

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EXTRACT: Energy analyst Fadel Gheit of Oppenheimer & Co. said he would like to see two giants of the industry he covers, Exxon Mobil and Royal Dutch Shell, begin to issue quarterly guidance. But without that, Mr. Gheit has kept “buy” ratings all year on both companies. He also owns their shares.

THE ARTICLE

Issuing Profit Forecasts
Bears Little on Chances
Of an Upside Surprise
By PETER A. MCKAY
July 23, 2007; Page C1

Fewer companies are issuing earnings guidance these days, but investors may not be missing much.

According to Thomson Financial, which tracks corporate profits, companies stand about the same chance of beating Wall Street’s profit expectations, regardless of whether their executives issue guidance — the financial industry’s term for detailed in-house forecasts of forthcoming quarters’ results.

• Background: Fewer companies are issuing earnings “guidance” these days.
• Investor Issue: Conventional wisdom has been that company executives try to keep earnings expectations low so that their actual results look better.
• The Twist: A study by Thomson Financial shows that companies beat earnings expectations at about the same rate whether or not executives issue earnings guidance.

Between 2001 and 2006, Standard & Poor’s 500 companies that issued guidance beat analysts’ expectations 65% of the time, while companies that didn’t issue guidance beat them 63% of the time, according to a recent Thomson report.

The research raises questions about the guessing game that plays out on Wall Street every earnings season. Conventional wisdom holds that executives “manage expectations,” or try to keep analysts’ profit estimates low ahead of profit announcements so actual reports will appear more impressive. Earnings forecasts move stock prices, although on average just 34% of S&P 500 companies issued quarterly guidance between 2001 and 2006.

With nearly two-thirds of companies beating expectations, the practice of keeping estimates low seems alive and well.

Forecasts may be more subtle than some investors realize. Companies can offer analysts significant hints about, say, the wonders of a new product or the difficulty of transporting goods, comments that fall short of the hard numbers that Wall Street traditionally defines as “guidance” but still provide information.

“What guidance is supposed to tell you is the direction of how things are going, not necessarily the exact number” where profits will come in, said Mike Thompson, research director at Thomson Financial. “There are a few different ways you can do that, using quantitative guidance or qualitative.”
Among big companies that don’t issue formal earnings projections, Coca-Cola beat analysts’ consensus estimate by three cents a share, or 4%, in the second quarter, according to Thomson. Merrill Lynch, which falls into the same category, beat expectations by 22 cents a share, or 11%.

Union Pacific does issue guidance and beat expectations by three cents, or 2%. General Electric also issues guidance and exactly met analysts’ consensus estimate.

Earnings announcements that miss expectations — up or down — can cause stock prices to make big moves. On Friday, earnings misses by Google, a notable holdout from issuing guidance, and Dow industrials component Caterpillar fueled a steep drop in the broader market, pushing major stock yardsticks into the red for the week.

The Dow Jones Industrial Average fell 56.17 points on the week, down 0.4%, to 13851.08, though it is up 11.1% this year. The S&P 500-stock index fell 1.2%, or 18.40 points, to 1534.10, and is up 8.2% on the year. The Nasdaq Composite Index fell 0.7%, or 19.40 points, to 2687.60, up 11.3% in 2007.

The practice of issuing quarterly guidance has been subject to criticism lately from some business and investor groups, saying it encourages short-term decisions by companies rather than long-term strategic planning and investment. Big-name market gurus who have lamented the ills of guidance include billionaire investor Warren Buffett and a former chairman of the Securities and Exchange Commission, William Donaldson.

“The risk involved with all this noise about the short-term estimates is that, in pursuit of quarter-to-quarter management, managers forgo important opportunities…or worse, that they spend time managing the numbers” through fraud, said Judith Samuelson, executive director of the business and society program at the Aspen Institute. The think tank recently convened a panel of executives to study long-term value creation at companies. The panel issued a set of principles for long-term management, including a recommendation that companies not issue quarterly guidance.

Data providers like Thomson that sell subscriber-based services to track profit expectations benefit from the quarterly hubbub over whether companies “make their numbers.” Thomson’s database, which offers a window into the predictions of competing Wall Street firms that otherwise wouldn’t share information with one another, also carries weight as a quasiofficial consensus prior to big announcements.

Stephen Biggar, director of U.S. equity research at Standard & Poor’s, wouldn’t like to see the practice curtailed. But he acknowledges his staff takes corporate guidance with a grain of salt and weighs guidance against other information gathered independently.

“We consider a company to have beaten expectations only if it exceeds the consensus number by 2% or better,” said Mr. Biggar, who said that, even by that more stringent standard, about half of companies beat Wall Street estimates. “We have to be aware of the Street’s game, the ways that a company will try to get estimates to the point where it’s easy enough to beat the number.”

Although the proportion of companies that beat expectations was similar regardless of their guidance policies over the period that Thomson studied, companies that gave guidance were better at meeting expectations on the nose. Companies that issue guidance met expectations about 24% of the time, compared with 16% of companies meeting expectations without guidance.

Companies that don’t issue guidance missed expectations 21% of the time, versus 11% among companies issuing guidance.

Energy analyst Fadel Gheit of Oppenheimer & Co. said he would like to see two giants of the industry he covers, Exxon Mobil and Royal Dutch Shell, begin to issue quarterly guidance. But without that, Mr. Gheit has kept “buy” ratings all year on both companies. He also owns their shares.

It helps that analysts who cover the energy industry can see one of the most important determinants of their companies’ success in real time — the commodity prices of crude, gasoline, natural gas and other fuels.

“What we can’t really know without the companies’ guidance is the effect of hedging programs and things like that,” said Mr. Gheit. “But you have a sense of how they’re doing. Most of them don’t miss the expectations by a mile.”

Write to Peter A. McKay at [email protected]

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