The Top Glove Incident

Many investors were up in arms when they read a certain financial publication’s front-page report on Top Glove Corp Bhd forewarning that its FY08 earnings are most likely to fall short of its earlier projection. Some even remarked that the headline “Top Glove issues profit warning” was somewhat irresponsible journalism.

But here’s a question - Was the executive director of Top Glove wrong to have guided the market that it was not going to be hitting its profit targets?

It’s earnings guidance, silly

Profit warnings are a common practice in the western world. In US, it’s called quarterly earnings guidance (QEG). European companies do not practise it and while it may not be mandatory in the US, it is generally expected of good companies.

When Top Glove was queried by Bursa Malaysia on the newspaper report, the glove maker stated that the headline was the publication’s own interpretation of an interview with its executive director, who in no uncertain terms said it did not expect to meet its target of RM125mil net profit for FY08.

The financial publication defended itself that companies must be encouraged to provide timely information, including any change in projections. Before we get to the “solutions”, let’s look at the developments surrounding QEG in the US.

The US Experience

Increasingly, large listed companies in America are revolting on the practice of providing quarterly earnings guidance (QEG) or in other words, company forecasts. In recent months, the move against quarterly guidance has become all the rage. Organisations such as the CFA Institute, the Business Roundtable, the Chamber of Commerce, the National Investor Relations Institute, members of Congress and Securities & Exchange Commission chairman Christopher Cox have sounded the alarm bell against companies providing quarterly earnings guidance to Wall Street and shareholders.

Needless to say, this kind of short-term managing will result in a difficult operating environment. Long-term objectives and strategy may be compromised to attain short-term goals and targets. QEG will not just affect the top layer of management, but will work itself down to the nuts and bolts of every organisation, especially sales and marketing. Constantly doing, re-doing, re-working, re-stating QEGs will create a damaging focus on meaningless short-term performance and undermine a company’s ability to manage for the long term. This re-working, re-stating, re-doing will have to be re-communicated down the line re-peatedly. Re-diculous!

Even I am concerned for quarterly reporting as I do feel there is an excessive burden on the board and senior management to do board papers, attend board meetings just to ratify and spot “typos” – a lot of constructive hours are lost. If we can maintain quarterly reporting to the bare minimum with no “special announcements or guidance” necessary ... it will save a lot of people a lot of time, money and creative energy.

Companies want to project numbers that will please Wall Street, their shareholders, the bloggers and excessive business programs on television. All company executives, especially those of large public companies, should follow the lead of others who have stopped issuing earnings guidance. Even stock analysts are disenchanted with QEGs as they have to write, comment on trivial things on a too-regular basis. Haven’t European markets and investors functioned just as well without very much forward guidance from management?

The highly respected Committee of Economic Development recently released a report entitled “Built to Last: Focusing Corporations on Long-Term Performance” (The Report). CED is chaired by former SEC chairman William Donaldson. The Report specifically recommends that “companies voluntarily refrain from issuing short-term guidance,” which, the Report notes, represents “both symbol and substance of concerns over companies’ lack of strategic focus on long-term performance.”

The Report observes that about half of listed companies continue to give quarterly guidance, but that “research studies indicate that quarterly guidance is at best a waste of resources and, more likely, a self-fulfilling exercise that attracts short-term traders.” The report cites a study of over 4,000 companies between 1997 and 2004, which found no evidence that guidance affected valuation multiples, improved shareholder returns, or reduced share price volatility. The study did find that the cost of management time and other resources of providing earnings guidance were significant.

The Report also notes that “the availability of information on short-term performance acts as magnet to those who trade based on such considerations,” but that “market pressure to provide earnings guidance may be receding,” since many companies are discontinuing the practice.

Berkshire Hathaway Inc chief executive Warren Buffett said Wall Street’s relentless focus on whether companies hit or miss quarterly earnings targets encourages balance-sheet manipulation and discourages long-range planning. A consensus is growing among CEOs, regulators and analysts to go against QEGs. Many CEOs despise giving such guidance but are afraid to stop because they think they would be punished by Wall Street analysts and shareholders.

Among the biggies who have stopped giving QEGs are Citigroup, General Motors, Ford, Motorola and Intel. Last Friday saw another big boy joining this elite group, Pfizer. Even Merrill Lynch has recommended its global research analysts to discount company guidance when preparing forecasts.

Many companies want to stop and maybe, part of the reason is that more and more companies have been missing their numbers. Particularly if you have had a great quarter, what are you going to forecast for the next quarter? If you are less than optimistic, then even that great quarter’s results will be villified and your stock will be graded down by analysts and business journalists. If you maintain an optimistic forecast, you are just raising the bar every quarter – how often can you raise the bar.

Not everyone has a “General Electric” at his disposal – not that I am bashing GE, GE has been famous for not missing QEGs. When you have a fantastically-run company with super achieving executives, and most importantly, an array of business units – you can “manage” earnings well. Tweaking business units performance on a quarterly basis, recording some sales early and some late – well, wouldn’t it be easy, especially when you have so many well-run units in GE.

CEOs have another quibble about QEGs and that is the increasing focus of class-action shareholder lawsuits. It is too short term in nature and volatile, and if CEOs are held liable for QEGs on a strict basis, it will be too stressful, if it isn’t already.

As in any markets, the top companies get too much research coverage while the rest get zilch. Two-thirds of Nasdaq companies are covered by one or no analyst. Small companies then feel obligated to play the QEG game simply to get attention. The one group who seems to benefit more from QEGs are the hedge funds, as they can have more opportunities to go long/short a stock/industry class based on QEGs. Hedge funds also tend to be more severe in rewarding and punishing short-term happenings. End result, more volatility.

Bursa & SC, Please Read

When QEGs were first proposed, it was based on the premise that they would help lessen volatility, and hence risk and cost of capital would also decrease. It should lead to better information flow and access for shareholders and potential investors. Suffice to say, those who thought so have formed the realisation that they were wrong in that respect.

What the Top Glove ED did was basically an earnings guidance. As things stand, he should not have made such a statement because it was not a regular or expected announcement. If we give the CEOs or CFOs leeway to make “earnings guidance” at any time to their convenience, we will leave a lot of room for possibly unethical intentions behind the timing of these guidance. In this instance, the ED must be warned not to do so in the future.

The SC & Bursa should come out with a set of “notes” on earnings guidance as well. If a company wants to be frank and transparent with their earnings guidance, they will have to announce to Bursa and investors beforehand that they should be doing so at regular and expected intervals. It ought to be clear and known to all – not whenever they feel like it.

Earnings guidance is not immaterial, or simply an opinion. As it comes from responsible senior management of the company, the guidance will have a material impact on share price. Hence Bursa and SC should look to close that gap with proper advice and well defined parameters to make things fair to shareholders as well.

This episode only reveals that this subject is a grey area, which the financial publication has inadvertently stepped into. Perhaps it’s time for more clarity from the regulators on the matter.

p/s photo: Pace Wu at the back, and the incredibly ageless Angie Chiu Ngar Chi in front (try and guess her age, she was the runner up in Miss HK 1973)