How to manage an earnings downgrade

Geoff Fowlstone argues that an earnings downgrade does not have to be your downfall.

How to manage an earnings downgrade

For many listed companies, the extreme volatility of the economic environment and the resulting challenges of accurately forecasting earnings go hand-in-hand with the stark reality that they will need to issue an earnings downgrade at some stage.

How each company manages this process – or more importantly, the impression the market has of how they manage the process – is crucial in determining the extent to which a company’s reputation may be damaged or its shareholder value destroyed.

Much of the pain endured by companies communicating an earnings downgrade can be avoided if they are prepared to engage the market, accept an appropriate level of accountability and provide sufficient detailed information for the market to understand and evaluate the implications.

Fowlstone Communications recently commissioned a study into the views of fund managers on earnings downgrades. It did this through a series of one-on-one interviews with 10 leading fund managers, who collectively manage funds of over $250 billion. The goal was to understand how fund managers view an earnings downgrade and to probe the key hot buttons.

Summary of the key findings

Common irritations

Fund managers are most aggravated by selective disclosure of a downgrade — there is a widespread view that many companies play favourites and tip-off one or two fund managers in advance. Other common irritations are announcements made late in the day or on a Friday and failing to schedule a conference call and presentation after making a downgrade. Also annoying is when the downgrade is a major surprise or contradicts previous guidance, and when a company claims a downgrade is a one-off when it isn’t. Director selling in a stock before a downgrade as well as downgrades issued immediately after a capital raising are also common frustrations, especially in the current economic climate.

Timing

Fund managers state that the earlier in the relevant accounting period a profit warning can be issued, the better. It should also be issued as soon as the board is aware of the information. In terms of process, issuing an announcement as early in the day as possible is preferable (before the market opens is ideal) and there is a strong preference for the judicious use of a trading halt.

Components of a downgrade

What fund managers want most from a downgrade announcement is significant detail about the magnitude of the downgrade and the key drivers affecting performance. The following basic information is considered a minimum starting point:

• Detail about how much revenue will drop.
• EBIT and EPS effect.
• Cash versus non-cash items.
• A separation of internal and external factors.
• A full update on the health of the business.

Factors that lead to a decision to sell a stock

Poor credibility of management is the most common reason fund managers cite as a trigger to sell a stock after a company has issued a profit warning. In particular, if management gets it wrong after making a call and when companies prove to be unrealistically optimistic, credibility is put at risk. This is particularly true if a view develops that management is not in control of factors the market believes should be under control or if there is a belief that the chief financial officer is not up to the task.

Avoiding the surprise element of a downgrade

Constant communication with the market and education about key drivers of a company’s performance are important factors in minimising the negative effect of a downgrade.

Fund managers said the surprise element of a downgrade can be tempered by giving the market an idea of factors that can negatively affect the result, so that they know what to look for. In addition, surprise can be minimised by consistently communicating detailed information about each segment of the business, rather than generalisations about the business as a whole, so that the market can understand the key drivers of earnings.

Re-building confidence after a downgrade

Transparency, honesty and delivering on promises made are the key factors that can help to restore confidence in a company after issuing a profit warning. Fund managers said that maintaining communication with the market after a downgrade helps to restore confidence and that over time, trust can be restored by talking to shareholders in person and getting results back on track. Ultimately it is about managing expectations.

Implications for directors

Based on my own experience and the findings of this research, a handful of important principles make an enormous difference to how much a share price falls following a downgrade and how quickly the company recovers.

Engagement

Failing to engage the market when issuing a downgrade adds fuel to the fire. This is multiplied when a company is perceived to be in hiding – common examples are failing to schedule a conference call or issuing a release late in the day or on a Friday. Investors expect the opportunity to question management and to have sufficient detail in public statements to accurately assess the effect of the downgrade. To do this, an announcement early in the day is preferable, along with a conference call to inform, and be prepared to answer questions.

Denial

Seeking to bury the bad news under immaterial good news looks like denial and indicates a lack of preparedness to accept accountability; this only leads to a further erosion of trust. This principle extends to the language used in the downgrade announcement, including attempts to blame the global recession when other, more specific, factors are to blame.

Serial downgrades

The tendency to not cut deep enough in the initial downgrade and to have to return two or more times to do so raises real questions about competence and judgment. It is far better to release all the bad news in one wave and move on.

Timing

Compliance with continuous disclosure obligations is axiomatic. Beyond this, releasing an earnings downgrade late in the relevant accounting period raises questions about the extent to which management has a handle on the business. The desire to attempt to fix problems during the balance of the year is obvious, but frequently leads to larger problems and the appearance of incompetence. Delays also raise question marks over the quality of internal systems and processes, and whether cultural issues are to blame – for example, whether a culture of blame exists where divisional managers are afraid to report on problems.

Management credibility

The credibility of management is a critical area fund managers assess and an area easily tarnished in a poorly managed downgrade. Any hint of dishonesty will instantly dismantle credibility and engender a general sense that management is not in control of factors in the business that should be under control.

Understanding builds trust

The best protection a company can have in advance of delivering bad news is a strong reputation with the market — credibility is everything. To be understood, a company must ensure the market is well educated on its business, particularly the key drivers of performance and the key risk factors. Frequent, constant communication with the market is essential to achieve this.

What to cover in a downgrade announcement:

• Clear guidance on the part or parts of the business that will disappoint, as well as all the other divisions and the business as a whole.
• A discussion of the precise factors leading to the downgrade, including separating one-off and continuing factors.
• Relative context about what the downgrade means for revenue, EBIT/NPAT/EPS, and an informed and unbiased opinion of the issues.
• Cash versus non-cash items.
• An explanation of what factors have changed, the effect of the change and why management is comfortable this will be the only downgrade.
• Clarity about what has gone wrong — not trying to hide problems — and a clear statement about how the announcement changes the company’s position in its market, along with management’s steps to correct the problem.
• Reconciliation with the prior period.

Geoff Fowlstone MAICD
Principal
Fowlstone Communications