Bridging The Earnings Divide

Dec. 21, 2004
Performance measurement has been a flash point between corporate executives and Wall Street analysts. Can the two sides look beyond the quarterly-earnings showdown?

Clearly, Wall Street analysts and the heads of publicly held companies need each other. Analysts need access to company management in order to draw accurate, comprehensive pictures of the firms they are evaluating. Executive teams need analysts to cover and, they hope, champion their stock. But some analysts say executives are not as forthcoming about expected earnings as they need to be. On the other side of the divide, some CEOs counter that analysts are obsessed with quarterly results, and pay too little attention to a firm's long-term strategy and initiatives to improve operations. While the two sides have their differences, in these post-economic-expansion days both appear to be paying greater attention to some of the same metrics to evaluate the performance of publicly held companies. "Both sides are looking at the same sorts of measures," says Adrian Dillon, executive vice president and CFO of Eaton Corp., the $8 billion Cleveland-based diversified industrial manufacturer. Both analysts and executives are relying less on financial results that are reported according to Generally Accepted Accounting Principles (GAAP). Instead, they are turning to economic income or economic profit. Why the switch? GAAP-reported results contain enough adjustments that sifting through them to find a company's true operating results becomes nearly impossible. It is also difficult to compare performance across firms. One example: Pension profits are included in GAAP-reported profits, even though they are usually not sustainable and are not related to operations, says Glenn Welling, an Irvine, Calif.-based managing director with Holt Value Associates, a financial consulting firm headquartered in Chicago. "There are a tremendous number of distortions in accounting data." Measures of economic income or profit try to eliminate the distortions and indicate just how effectively firms are using their assets to generate returns above their cost of capital. "What's important is not just what you make, but what you spend to make it," notes Neal Cannon, senior vice president with Financial Relations Board Inc., a Chicago-based investor relations firm. For manufacturing companies, measures of economic income are particularly relevant, says Robert Mataya, vice president of business planning and development, Material Sciences Corp., a $480 million manufacturer of steel and other products based in Elk Grove Village, Ill. "It's a useful tool for companies that make things, have assets, and have to make investments," says Mataya. Material Sciences adopted economic value-added (EVA) in the fall of 1997, and soon after picked up several new large shareholders, he adds. While it would be an overstatement to say that a company's adoption of EVA or a similar measure automatically will lead to new investors, a number of portfolio managers and institutional investors are zeroing in on these metrics. "What each metric does is relate the income statement to the balance sheet. For a well-run company, over time those two are tied together," says Ron Muhlenkamp, president of Muhlenkamp & Co. Inc., a Wexford, Pa.-based investment management firm with $650 million under management. While the income statement generally gets the most attention, the balance sheet also is an important gauge of a company's health and per-formance, says Muhlenkamp. If the balance sheet is too strong, it is a signal that management is not optimizing the equity invested in the firm. If it is chronically weak, the company will have trouble getting through an economic downturn. For instance, cash is king in the auto industry right now, says Domenic Martilotti, auto analyst with Bear Stearns Cos. Inc., New York. "We're at the bottom of the [economic] cycle, and companies are losing dollars," says Martilotti. "So we're looking at cash balances and how much cash they're actually burning. The one with the strongest cash position tends to get the strongest valuation." Material Science's experience with EVA brings up an important consideration for company executives: While the "sell-side" analysts, who typically work for investment banks and issue reports on different stocks, tend to grab much of the press, they are not the only analysts. The "buy-side" investors and analysts, such as portfolio managers and institutional investors, make up another important audience. "Executives tend to have more exposure to the sell side. The buy side tends to be a lot of firms that people never heard of," says Justin Pettit, a partner with Stern Stewart & Co. in New York. As a result, it can become easy for executives to pay too much heed to the suggestions that an investment banker may make, says Pettit. Many investment bankers work at the same firms as sell-side analysts, and their advice in dealing with Wall Street may be perceived as particularly insightful. He provides an example: An investment banker may pitch a manufacturing firm on a merger deal involving a finance company, with the rationale that owning a finance arm will help smooth fluctuations in the firm's quarterly earnings. Less earnings volatility could help the firm in its discussions with Wall Street analysts. However, portfolio managers and institutional investors are less likely to be persuaded that such logic makes sense, says Pettit. "The buy side will look at [whether] you will have a competitive advantage in the challenging business of financing. If it will not create value, you're best off not being in that sector." Quarterly Results Over the last few years as technology stocks set a new standard for performance, one of the more contentious areas of discussion between executives and analysts has concerned the impact of quarterly earnings releases. Some executives have charged that Wall Street focuses too intensely on minor ups and downs in the numbers. As a result, the argument goes, stock prices fluctuate out of proportion with results. However, to the extent that quarterly results provide a window on future operations, a drop in the stock price may not be out of line. Pettit of Stern Stewart notes that a quarterly difference of a penny per share that continues over 10 years equals a long-term change of 40 cents per share. What's more, analysts often grow concerned that the gap between real and expected earnings will widen as time goes on. Thus, the beating stocks can take when earnings fall short is a result of significant changes in the firms' long-term prospects. Tom Copeland, managing director with Monitor Corporate Finance, a Cambridge, Mass.-based consulting firm, studied analyst expectations of companies' short- and long-term prospects, and their link to shareholder return. The strongest link was between long-term -- not short-term -- expectations, and share price. The upshot, according to Copeland: "All the window dressing to manipulate short-term earnings is ignored by the market." Others agree. Dillon of Eaton says that communication between Wall Street and many executives has improved. Especially since the Security and Exchange Commission's Regulation Fair Disclosure rules went into effect last year (requiring that companies simultaneously make information available to analysts and the public), a number of companies, including Eaton, have provided more information on events and trends in their markets, along with the numbers seen on the financial statements. "It's been a very deliberate change in strategy, and it's paid off wonderfully well," says Dillon. Proof of this can be seen in Eaton's stock. As of Sept. 10 the company's stock was trading at about $70. That was off its 52-week high of $81, but well above the low of $58. "It's a manifestation of the confidence Wall Street has in us," says Dillon. Other executives say that analysts have reacted positively to their implementation of longer-term quality programs such as Six Sigma. IDEX Corp., a $700 million manufacturer of engineered pumps and industrial products based in Northbrook, Ill., initiated a Six Sigma program a little over a year ago. While the company isn't likely to see much positive financial impact from the program this year, analysts have encouraged its use, says Dennis Williams, president and CEO. That's been true even as the economy has slowed. "In meetings with analysts, they've said, 'We hope that you're not stopping Six Sigma.'" Words of Caution At the same time, analysts also stress that Six Sigma and other quality programs ultimately need to either boost sales as customers notice the improved quality or reduce costs as operations become more efficient. Just the promise of better performance isn't enough. "What's difficult with Six Sigma is that it's really hard to know what's going on, versus [financial statement] numbers, which are publicly audited," says Louis Miscioscia, an electronic-manufacturing-sector analyst for Lehman Brothers Holdings Inc., New York. And, despite the growing use of measures of economic profit, some analysts are not convinced that these measures are all they're cracked up to be. "EVA has been frustrating," says Richard Eastman, managing director in research with investment firm Robert W. Baird & Co. Inc., Milwaukee. While EVA or a similar measure may induce companies to sell underperforming assets -- a good move -- management still needs to find another way to effectively deploy the funds generated by the sales. Otherwise, they are simply downsizing rather than increasing profits, he says. Eastman focuses his analyses on earnings and earnings growth. "Longer-term earnings growth and consistency in earnings growth is number one," he says. However, not everyone is convinced that both executives and analysts are looking at the right measures, or working in unison. "The investment community tends to look more narrowly," says Joseph DeFeo, president and CEO, Juran Institute Inc., a Wilton, Conn., training and consulting firm. If analysts and investors really want to know how a company is likely to do, they should spend more time looking at such forward-looking attributes as quality and customer satisfaction, and less time scrutinizing historical financial results, he advises. However, DeFeo notes that things have changed over the last 12 months. With the tightening in the economy, more investors have been looking more closely at measures of future performance, he says. What do these trends in analysts' expectations mean for managers? Experts offer the following guidelines:

  • As much as possible, provide investors with unbiased, accurate information regarding your firm's long-term strategy. "You have to give your best unbiased estimate," says Monitor Corporate Finance's Copeland.
  • Make decisions that are economically sound, even if they negatively impact accounting numbers. "The most successful companies have the view that decisions ought to be based on the right economic basis," says Stern Stewart's Pettit. One example: Executives may not want to sell underperforming assets because they will be hit with a book loss. However, if executives can clearly articulate the reasons behind the move to analysts, the stock should hold up. "The money that matters will see through the accounting," adds Pettit.
  • Try to manage analysts' expectations. Copeland notes that management can report good results, but still see their stock price sink if their firm's performance doesn't match expectations. "When you're trying to link measures of financial performance to stock prices, it's important to keep the role of expectations in mind. You have to exceed expectations to achieve value," says Copeland.
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