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March 03, 2005

Reg FD and Earnings Projections Part 2

Giving explicit earnings projections is a bad idea for most companies.  An article in a recent Wall Street Journal documents a large decline in the percentage of companies making such projections.  Yesterday I blogged about Regulation FD (Fair Disclosure) which has changed the way companies make financial and other information available.

Prior to the promulgation of Reg FD in late 2000, most companies had “confidential” discussions with security analysts in which the companies helped analysts develop their projections for the company.  This help ranged from doing all the work for the analysts by sharing the company’s internal projections to just pointing out where there were flaws in draft analyses.  After the discussions, analysts developed their “own” projections for the company which investors certainly used in making investment decisions.

FD made very clear that this type of discussion could not continue - information which was made available to analysts would have to be made fully publicly available by the company itself to create a level playing field.  The SEC asserted, with good reason, that the detailed information given the analysts ended up giving the big clients of the analysts and the brokerage firms a leg up on the general investing public.

So far so good.

The problem is that, without this information, analysts really don’t have enough information to create projections for many companies.  Sure, if they are projecting something like GM sales they can look at all the things that have historically been a leading indicator of car sales like disposable income and interest rates and the average age of the national fleet, multiply by a projection of GM’s shrinking market share, and come up with a pretty respectable if not usually accurate number.  But, for new companies, especially new companies in new or radically transformed industries, without the information which used to be available to them, the analysts don’t have enough data to make projects.  Or, a cynic would say, the analysts have to work too hard to make a projection if the company doesn’t hand them the data on a silver platter.

Since Reg FD coincided with the collapse of the bubble and general cutbacks in brokerage businesses, there were now less analysts with less assistants available to cover companies and they had less information to work with.  The result was both less projections by analysts available to investors and even less accurate projections by those analysts still willing and able to make them.

So, post FD, if a company wants its investors to have financial projections to look at, in many cases the company has to make these projections itself.  As CEO of ITXC, I decided that we should make public projections because I wanted our investors and potential investors to know what we thought would happen with the company.  Good intent but I would advise CEOs of most public companies NOT to do this.

Backing up for a minute, every company has internal projections.  You can’t run a company without them.  You have to know how many people to hire (or fire).  How much equipment to buy, space to rent etc. etc.  Your board can’t approve your budget unless they are shown projections of sales, pricing, costs and all sorts of other speculation on the future.  And no sane company would make all of this data publicly available.  You don’t want to expose it to competitors, customers, suppliers, or even employees in some cases.  And, in detail, the estimates are even more likely to be wrong than when aggregated to simple numbers like gross sales and profitability.

A private company with few investors, all of whom may be board members, can make this detailed information confidentially available to its investors.  Under Reg FD, analysts can’t be given even a subset of the detailed data unless it is made fully public which it can’t be for competitive and other reasons.

So, again, if investors are to have the information provided in financial projections, those projections have to come from the company in many cases.  Any securities lawyer will tell you that financial projections, if they turn out to be wrong, are the perfect fodder for shareholder class-action suits.  However, what the law requires is that management believe in and have good reason to believe in projections at the time that they are made (and that all the appropriate mind-numbing disclaimers about “forward-looking statements” be properly made). I didn’t let the fear of lawsuits deter us then and I don’t think CEOs can afford to be paralyzed by the threat of law suits today.  In general, you have to communicate with investors and, if you communicate anything about the future, you will sometimes be wrong; that’s a risk worth taking.

The reason I’d advise against public financial projections is that they add to the pressure to manage for quarterly results.  Once you’ve stuck your neck out and predicted something to the whole world, there is a lot of pressure – some of it self-generated -  to make that prediction come true.  Circumstance change.  It may be impossible to meet the original goals.  It may not even be desirable to reach the original goals.  For example, an unforeseen opportunity may require investment which reduces profits for a quarter or two.

Some have cited the need to make quarterly numbers as an explanation for the chicanery in places like Enron and WorldCom.  There is no excuse for lying and cheating.  That is not what I’m talking about.

There are, however, many honest and honorable ways to make bad decisions once you’ve made a public projection.  It starts with the fact that a public prediction, once made, begins to consume an inordinate amount of executive mental bandwidth.  For example, once you know that a prediction is wrong, you have to be public about that; you have to give a warning.  But when do you know for sure?  You have to think about that every day if it’s even close.  And, if it is close, do you reduce prices slightly to gain sales in the quarter and make “the number” or do you optimize for long-term cash flow by holding the line on prices?  Do you focus everyone on things that produce near-term results or do you allocate resources to the future?  Do you cut the ad budget because that won’t hurt until next quarter?  These decisions are hard enough without the pressure of a public number to make.

Computer and software companies are famous for holding quarter-end sales.  A savvy buyer waits until the end of a quarter for any substantial purchase because he or she knows that there will be a good price if the company is struggling to make its quarterly number.  Of course, for the selling company this behavior is self-defeating because it steals sales from the next quarter AND trains customers to wait for sale prices next time, too. 

Fortunately, selling wholesale voice minutes as we did at ITXC, we didn’t have this particular dilemma because the carriers who were our customers bought when their customers made calls and that’s when we booked sales.  There is no such thing as in inventory of minutes.

A company has to have goals and they should be broken down into quarters.  Internally, a CEO needs to manage to projections and hold people accountable for quantifiable results.  A good board of directors also watches results and wants to know why any deviations from plan.  But my advice is NOT to make these projections public.  Let results speak for themselves.  And, especially in a new business in a new industry, concentrate investor communication on explaining the industry, the company, its strategy, and the changes that are taking place.  A CEO blog is a good way to do that – although lawyers won’t like that any more than they like financial projections.

[Full disclosure: I had good advise NOT to make public financial projections from other executives at ITXC.  It was something I had to learn from experience.]

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