Recent events have put companies on notice that practices that have been rubber-stamped by regulators for years might suddenly be declared illegal. They have also demonstrated that executives can't be too careful when drafting public communications: allegations are no longer based just on outright lies and omissions but also on words or phrases said to create a misleading impression. One recent example was the SEC's investigation of American International Group, in which the SEC and the US Justice Department found fault with several press releases.
To stay out of the crosshairs, companies have to examine everything they say and do through the eyes of ambitious prosecutors, questioning any practice that might be misunderstood by an unsophisticated investor.
One long-standing practice that might invite scrutiny is the management of investor expectations. The press and investors never cease to be impressed by companies that ?exceed Wall Street estimates?, so most companies try to do this. There are two ways to achieve this goal: either perform better than expected, or try to set expectations below the level at which you expect the company to perform. Successful companies often try to do both.
The risk is that the same logic that gets companies sued for exaggerating expected performance might leave them open to allegations that they are intentionally low-balling, with plaintiffs for hire being those investors who dump stock before an impressive earnings announcement ? or even those who don't buy stock in the first place ? because they take expectations at face value. So companies need to choose their words carefully.
Thousands of companies manage expectations in one way or another, so it is unfair to single out any one company (although this, of course, is what a prosecutor would do). For an illustration of the risk, however, one might look at leading internet commerce player eBay. eBay is an extraordinary company with superb disclosure. The wording it uses in its press releases, however, might leave it exposed to the charge described above.
Every quarter for more than a year, eBay's earnings releases have announced record performance and noted that the company is, once again, ?raising guidance?. The releases have also explained that the quarter ?exceeded the company's guidance? detailing by how much.
To anyone who has followed eBay's history, these sentences are meaningless. The results always exceed guidance. ?Guidance?, however, is a sufficiently vague term that one would be hard-pressed to accuse eBay of misleading anyone. After all, given the risk associated with over-promising and under-delivering, who could blame the company for being intentionally and prudently conservative?
Guidance versus expectation
The potential trouble comes later, in the language the company uses to describe its updated ?business outlook?. In October, when it announced spectacular third-quarter results, this read: ?eBay now expects that consolidated net revenues for 2004 could be as high as $3.25 billion.? The new earnings outlook was similarly encouraging: ?eBay now expects that [earnings per share] for the full year 2004 could be as high as $1.20... From a quarterly perspective, eBay estimates that [EPS] could be as high as $0.32 in Q4-04.?
Consider ?eBay now expects that revenues and earnings could be as high as...? Unlike the word ?guidance? the plain-English meaning of this phrase is clear. The trouble is, depending on one's familiarity with the company, the message received is different. A layperson might take ?eBay expects that Q4 EPS could be as high as $0.32? to mean that the company expects EPS to be, say, $0.31 or $0.32. The eBay-aficionado, meanwhile, would read the words as, ?eBay expects Q4 EPS to be at least $0.34 and would consider anything less a disappointment?.
Why would the eBay-aficionado read the words this way? Because historically the company has shown a supernatural ability to expect performance that turns out to be a few percentage points or pennies too low, quarter after quarter after quarter. In late 2002, for example, eBay expected that 2003 earnings could be ?as high as $1.15?. It then revised its expectations upward every quarter for five straight quarters before finally reporting earnings of $1.50. In late 2003, eBay expected that 2004 earnings could be ?as high as $0.98?. Four quarters later, the expectation has risen to $1.20, and no sentient analyst could think the company expects to report anything less than $1.22.
Is it possible that eBay ? and other companies ? just surprise themselves quarter after quarter, failing to learn that performance is always a bit better than expected? Yes. According to eBay spokesperson Hani Durzy: ?The guidance we provide every quarter is based on the best information we have at our fingertips at the time.? Even so, companies might be well advised to just say: ?Our guidance is,? rather than ?We expect...? Otherwise, hungry prosecutors might start sifting through finance-department emails, hoping to find a wisecrack about how well the company plays the expectations game.
Henry Blodget built a reputation as a star internet analyst at CIBC Oppenheimer and later at Merrill Lynch. Then, in 2003, a joint investigation by the SEC, NYSE and the NASD found that he had made derogatory statements about stocks in private emails that were inconsistent with recommendations in published research reports. The case never went to court and Blodget neither denied nor admitted the charges. However, he agreed to pay a fine and disgorgement totalling $4 million and was permanently prohibited from working in the securities industry. Deprived of this source of income, Blodget is putting his knowledge to good use as a writer.